GROUP 20 Topic 3 – FED Discount Rate


A Brief Introduction:

The discount rate is the interest rate charged to commercial banks and other depository institutions on loans they receive from their regional Federal Reserve Bank’s lending facility–the discount window. The Federal Reserve Banks offer three discount window programs to depository institutions: primary credit, secondary credit, and seasonal credit, each with its own interest rate. All discount window loans are fully secured.

A tight link between the equilibrium rate and growth is common in theoretical models. The Ramsey model relates the safe real rate to a representative consumer’s discount factor and expected consumption growth. So, too, does the baseline New Keynesian model, whose generalization is central to much policy and academic work. Thus these familiar models tie the equilibrium rate to the trend rate of growth in consumption and thus the economy. In those models, shifts in trend growth will shift the equilibrium rate. 

In other words, the equilibrium rate may be time varying. Such time variation is at the forefront of the policy debate.

The federal funds rate over time:

The effective federal funds rate is the interest rate at which depository institutions—banks, savings institutions (thrifts), and credit unions—and government-sponsored enterprises borrow from and lend to each other overnight to meet short-term business needs. The target for the federal funds rate—which is set by the Federal Open Market Committee—has varied widely over the years in response to prevailing economic conditions.

Comparing The Fed Funds Rate With The Primary Credit (Discount) Rate Over The Past Decade

Much has been said about the 25 basis point Discount Rate rate hike announced on Thursday. Some suggest that this was fully expected, priced in, and that to the Fed this is merely a technicality which will not impact the Fed Funds rate in the least. Others, such as Macro-Man, take a decidedly more pragmatic approach, and ask the simple question: if it really means nothing, why do it? « He » also goes on to suggest some possible trade ideas as a result of this action: we suggest checking out his post for further information.

Instead of speculating what the Fed may or may not do (we doubt even the Fed knows – as Krugman points out, the Fed’s action could be a function simply of what political party is currently in charge), we have decided to show a simple comparison of the Discount Rate and the Fed Fund rate over the past 10 years (chart below). A few things jump out: before the crisis started in 2007, the spread between the Fed funds target rate (5.25%) and the primary credit, aka discount rate, which was a 6.25%, was 100 bps. The first notable action that the Fed did vis-a-vis the discount rate was to cut it by 50 bps to 5.25% on the morning of August 17, 2007 (in the heyday of the quant implosion when the market was gyrating like a drunken sailor courtesy of busted quant models at GS Alpha and other core quant shops). The spread was subsequently cut to 25 bps on March 16, 2008, when Bear was unceremoniously handed over to JP Morgan for pennies on the dollar. It remained there until Thursday, when it has again moved to 50 bps.

Looking at the chart demonstrates that there has been not one period over the past decade when there was a substantial widening divergence ever since January 9, 2003, when the current discount rate system (primary, secondary) took over the old system in which adjustment credit, extended credit and seasonal credit were the primary forms of crediting available to depository institutions (which in itself is of course an anachronism – only some of the current Discount Window institutions are, in fact, depository institutions, but that is the topic of another rant). We encourage readers to take a look at 12 C.F.R. Part 201 and Part 204, which was the final ruling for conversion to the current discount rate system, it is a rather interesting analysis (not to mention the fact that prior to 2003, the discount rate was inside the Fed Funds rate, thereby allowing banks to arb the Fed once again, only in a different manner). But in summation, any increase in the primary credit rate has always been followed in parallel, or shortly thereafter, by an increase in the fed funds rate. Just how different will this time be?

As Stone McCarty points out « It is also probably not an accident that the announcement of tomorrow’s discount rate hike (and next month’s shortening of loan maturities) comes just after the release of the January 26-27 FOMC minutes. The discussion in those minutes further serves to underscore the technical, as opposed to policy, nature of today’s move. » Yet we think that there is more to this, as the Fed will sooner or later be forced to come face to face with a broken monetary system, in which it stands to lose all control should it not tighten in advance of a potential monetary supply explosion which would lead not only to hyperinflation (should the Fed gets its way, and consumers finally start borrowing), but also to full loss of the Fed’s control over the American monetary system. Keep a close eye on this chart: we are confident that the Fed Funds will be hiked before there is another unsymmetrical increase in the discount rate. Alas, the economy is far too weak to sustain a tightening posture at this point. As to what kind of aberrations in the market this action could lead to, we will investigate in the coming days and weeks. Even though the point of this work is to analyse the FED federal discount rate in those past 10 years, it is important to go further back to understand what happened before 2007. Between May 2000 and December 2001, the rate was decreased 11 times, falling from 6,5% to a low 1,75%. This created a flow of cheap liquidity now available for banks to borrow to households, thus laying the foundations of what would be know as the subprime crisis in 2008.

It became apparent in August 2007 that the financial market could not solve the subprime crisis on its own and the problems spread beyond the United State’s borders. The interbank market froze completely, largely due to prevailing fear of the unknown amidst banks. Northern Rock, a British bank, had to approach the Bank of England for emergency funding due to a liquidity problem. By that time, central banks and governments around the world had started coming together to prevent further financial catastrophe.

The subprime crisis’ unique issues called for both conventional and unconventional methods, which were employed by governments worldwide. In a unanimous move, central banks of several countries resorted to coordinated action to provide liquidity support to financial institutions. The idea was to put the interbank market back on its feet. The Fed started slashing the discount rate as well as the funds rate, but bad news continued to pour in from all sides. Lehman Brothers filed for bankruptcy, Indymac bank collapsed, Bear Stearns was acquired by JPMorgan Chase (NYSE:JPM), Merrill Lynch was sold to Bank of America, and Fannie Mae and Freddie Mac were put under the control of the U.S. federal government.

By October 2008, the Federal funds rate and the discount rate were reduced to 1% and 1.75%, respectively. Central banks in England, China, Canada, Sweden, Switzerland and the European Central Bank (ECB) also resorted to rate cuts to aid the world economy. But rate cuts and liquidity support in itself were not enough to stop such a widespread financial meltdown.

The U.S. government then came out with National Economic Stabilization Act of 2008, which created a corpus of $700 billion to purchase distressed assets, especially mortgage-backed securities. Different governments came out with their own versions of bailout packages, government guarantees and outright nationalization. The bill was, and still is highly controversial; it was seen by many as a ‘bailout’, and affected much of the American population through greater taxes. This has also caused a general distrust of banks, with many considering them ‘too big to fail.’

The Equilibrium Real Funds Rate: Past, Present and Future, by James D. Hamilton, University of California at San Diego and NBER – March 1, 2015


The 2007-08 Financial Crisis In Review | Investopedia

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