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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.