This article aims to show you the evolution of the Federal Reserve’s discount rates over the last 10 years.
Nevertheless, before going into any details, let me briefly explain you what is the Federal Reserve and how it influences the economy.
What is the FED ?
The Fed is the gatekeeper of the U.S. economy. It is the bank of the U.S. government and, as such, it regulates the nation’s financial institutions. The Fed watches over the world’s largest economy and is, therefore, one of the most powerful organizations on earth.
« To promote sustainable growth, high levels of employment, stability of prices to help preserve the purchasing power of the dollar and moderate long-term interest rates ». That is the Fed’s mandate and it clearly shows how it broadly impacts the US economy.
The Discount Rates are one of the FED’s main Tools to regulate the monetary system. Here is how they are used.
What are discount rates ?
The federal funds rate is the interest rate at which depository institutions trade federal funds (balances held at Federal Reserve Banks) with each other overnight. When a depository institution has surplus balances in its reserve account, it lends to other banks in need of larger balances. In simpler terms, a bank with excess cash, which is often referred to as liquidity, will lend to another bank that needs to quickly raise liquidity. The rate that the borrowing institution pays to the lending institution is determined between the two banks; the weighted average rate for all of these types of negotiations is called the effective federal funds rate. The effective federal funds rate is essentially determined by the market but is influenced by the Federal Reserve through open market operations to reach the federal funds rate target.
FED’s LAST 10 YEARS DISCOUNT RATES
For nearly six years, the Federal Reserve has held short-term interest rates at essentially zero to support the economy after the 2008 financial crisis. The severity of the Great Recession, and the Fed’s inability to lower interest rates below zero, led policy makers to use unconventional tools to stimulate the economy, such as quantitative easing (i.e., large scale asset purchases) and forward guidance. With strong employment gains and an improving economy, the Fed is now preparing the market for an eventual rate increase, perhaps as early as June 2015.
Past fed rate hike cycles
An exploration of past Fed tightening cycles starts with a review of how monetary policy adjustments work. One of the main tools Fed officials use to adjust policy is the federal funds rate. Whenever policy makers want to slow the growth rate of the economy and restrain inflation, they may raise interest rates, which is known as “tight”, “restrictive” or “contractionary” monetary policy. Conversely, whenever policy makers desire to spur the growth rate of the economy and increase the supply of money and credit, they lower interest rates, known as “easy”, “expansionary” or “accommodative” monetary policy.
Leading into the first rate hike
In most tightening cycles, inflation had either held steady, or only started to gradually rise after the Federal Reserve began to hike interest rates. It appears that the Fed’s decision to raise rates in each of the tightening cycles was driven by trends in the labor market and the central bank’s desire to be preemptive on the inflation front, rather than reacting to rapidly rising inflationary pressures.