What does a lower discount rate mean for you?
Today’s topic is understanding what a lower discount rate means for you.
Samir in New Jersey called in with this question:
“Hi Money Girl. This is Samir. Today, the Federal Reserve, in an emergency action, lowered the discount rate. I guess they don’t normally do this and they did this because the stock market has been dropping. Can you explain what it is they lowered? What is this discount rate and why they would have done this before their next meeting? I’ve never heard of this before. Again, this is Samir from New Jersey and I love your show.
Thanks for the question, Samir!
What Is the Discount Rate?
Ok, to start off, what is the discount rate?
The discount rate is the interest rate a regional U.S. Federal Reserve bank charges to make loans to depositories (such as banks and credit unions) to meet temporary cash shortages. On Friday, August 17, 2007, the Federal Reserve lowered the discount rate by half a percent from 6.25 down to 5.75 percent. It was the first time the Fed approved an emergency cut to the discount rate since immediately following the attacks of Sept. 11, 2001. The Federal Reserve also extended the time that banks can take to repay the loans from one day up to 30 days. It also made the loans renewable.
A related term you’ll hear in the financial news is the discount window. The discount window is the lending the Federal Reserve does at the discount rate.
Don’t Confuse Rates
It’s pretty common for people to confuse the discount rate with the federal funds rate, but they’re not the same thing. The federal funds rate is the interest rate that banks charge each other for overnight loans. It’s currently 5.25% and it’s the rate that directly impacts the rate you pay on consumer loans, such as credit cards, car loans, and home equity lines of credit. The discount rate does not directly affect these sorts of consumer interest rates.
The Federal Open Market Committee (which includes the presidents of the 12 regional Federal Reserve Banks) sets the target for the federal funds rate and it’s typically about one percent lower than the discount rate. As a result, it’s more attractive for banks to borrow money from other banks before seeking funds from the Federal Reserve at the discount rate.
Typically, banks don’t borrow from the Fed’s discount window unless there’s a crisis and borrowing through normal channels becomes difficult. Although the Federal Reserve has made attempts to change the perception, the Fed’s discount window is considered the “lender of last resort” for banks and, as a result, there’s still a stigma associated with borrowing from it.