Discount Rate vs. Fed Funds Rate

What is the difference between the Discount Rate and the Fed Funds Rate?

On Thursday February 18th, the Federal Reserve surprised the markets by raising the discount rate by 25bp to 0.75 percent, sending the U.S. dollar sharply higher against all of the major currencies. Although the Fed went out of their way to say that this does not equate to a change in their monetary policy outlook, action speaks louder than words.

The discount rate is different from the Federal Funds or overnight lending rate.

The DISCOUNT RATE is the rate charged to commercial banks and other depository institutions on loans that they receive from the Fed

The FED FUNDS RATE is the rate that banks charge each other for loans.

By hiking the discount rate and not the Fed funds rate, the central bank has in essence encouraged banks to borrow from the market over the Fed without hurting households. The Fed also shortened the terms of primary loans to overnight from 90 days.

This is a game changer for the foreign exchange market and should lead to further gains in the dollar over the next few weeks (Kathy’s CNBC Video Interview on the Fed Announcement).

The U.S. central bank attempted to temper their comments by saying that their outlook for the economy and monetary policy is unchanged and that rates will remain low for an extended period. The most important takeaway is that the Fed is beginning to implement an exit strategy which is more than what many of the other central banks are doing and therefore this action will be extremely positive for the dollar.

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10 Comments

  1. From an amateur point of view: was this surprising at all?
    Last month, the BoE stopped QE (no wonder, after looking at the CPI for December and January), and the new rules of the ECB (increased haircut, higher rating on the collaterals when borrowing money from the ) will kick in.. 10 days?
    Even more – the Chinese central bank started draining liquidity as well… isn’t the FED just keeping up with everyone?

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  2. Let’s see how the bond sales go next week… And whether investors shy away from TIPS and buy up unprotected bonds instead…

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  3. what would happen when the discount rate is higher than fed fund rate, in this regard keeping the fed fund rate constant? How does market work itself? Which move(discount or fed rate) will be better for the current economy? Thanks.

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  4. I think the US bond sale of $126 billion this week will be difficult… They’ll have to sell to low price/high yield as buyers will count on inflation picking up later in the year. I’m also afraid China will show their anger with the meeting between Obama and the Dalai Lama by staying out of the bidding thereby sending a message of unwillingness to finance US debt. This will weigh heavily on the credibility of the dollar. FED policy makers are currently talking down rumors about about a rate hike coming any time soon, which also fuels worries of inflation later this year.

    This results in loss of confidence in policy making and the US making good on it’s promise to repay debt without letting the value of the currency suffer. At the same time we now get to hear that Axel Weber will take over after Trichet as ECB president. Weber is a well known inflation hawk who will most likely increase confidence in Euro policy.

    I think this week could be a turning point for the EUR/USD where the dollar weakens against the Euro.

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  5. @TinTin

    If I have it right the discount rate is a ceiling for the federal funds rate. The Fed prefers banks borrow amongst themselves and use the discount window as a last resort. So they keep the discount rate higher to encourage that behaviour.

    One addition to Kathy’s excellent take: The federal funds rate is the rate that banks lend each other from their reserves stashed at the fed. It’s an important point because it enables the fed to manipulate the rate.

    To lower reserves and drive up the federal fund rate (supply and demand) they’ll sell securities to banks and the banks will pay with their reserves. Because there are now less reserves to loan around they’re more expensive, i.e., the federal funds rate goes up.

    To lower rates the fed will buy securities which increase the reserves of the bank(s) they buy from. Because there are now more reserves the federal funds rate goes down.

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