What is a discount rate?
A discount rate is the interest rate at which a country’s central bank lends money to national banks, often in the form of very short-term loans. The management of the discount rate is a method by which central banks affect economic activity. Lower bank rates can help grow the economy by lowering the cost of funds for borrowers, and higher bank rates help rule the economy when inflation is higher than desired.
Key points to remember
- The discount rate is the interest rate charged by a country’s central bank for borrowed funds.
- The Board of Governors of the US Federal Reserve has set the discount rate.
- The Federal Reserve can increase or decrease the discount rate to slow down or stimulate the economy, respectively.
- There are three types of credit issued by the Federal Reserve to banks: primary credit, secondary credit, and seasonal credit.
- Unlike the bank rate, the overnight rate is the interest rate charged by banks that lend funds to each other.
How bank rates work
The discount rate in the United States is often referred to as the discount rate. In the United States, the Board of Governors of the Federal Reserve System sets the discount rate as well as the reserve requirements for banks.
The Federal Open Market Committee (FOMC) buys or sells Treasury securities to regulate the money supply. Together, the discount rate, the value of treasury bills and reserve requirements have a huge impact on the economy. Managing the money supply in this way is called monetary policy.
Types of discount rates
Banks borrow money from the Federal Reserve to meet reserve requirements. The Fed offers three types of credit to borrowing banks: primary, secondary and seasonal. Banks must present specific documentation depending on the type of credit granted and must prove that they have sufficient collateral to secure the loan.
Primary credit is granted to commercial banks with sound financial standing. There are no restrictions on the use of the loan, and the only requirement for borrowing funds is to confirm the amount needed and the loan repayment terms.
Secondary credit is given to commercial banks that do not qualify for primary credit. Because these institutions are not as strong, the rate is higher than the primary lending rate. The Fed imposes usage restrictions and requires more documentation before issuing a credit. For example, the reason for borrowing funds and a summary of the bank’s financial position are required, and loans are issued for a short term, often overnight.
As the name suggests, seasonal credit is given to banks that experience seasonal variations in liquidity and reserves. These banks must establish a seasonal qualification with their respective reserve bank and be able to demonstrate that these fluctuations are recurrent. Unlike primary and secondary credit rates, seasonal rates are based on market rates.
Discount rate vs overnight rate
The discount rate, or discount rate, is sometimes confused with the overnight rate. While the discount rate refers to the rate the central bank charges banks to borrow funds for, the overnight rate, also known as the federal funds rate, refers to the rate that banks charge each other when they borrow funds from each other. Banks borrow money from each other to cover shortages in their reserves.
The discount rate is important because commercial banks use it as the basis for what they will eventually charge their customers for loans.
Banks are required to have a certain percentage of their deposits set aside as reserves. If they don’t have enough cash at the end of the day to meet their reserve requirements, they borrow it from another bank at an overnight rate. If the bank rate falls below the overnight rate, banks typically look to the central bank, rather than themselves, to borrow funds. Therefore, the discount rate has the potential to drive the overnight rate up or down.
As the bank rate has such a big effect on the overnight rate, it also affects the consumer loan rates. Banks charge their best, most creditworthy customers a rate very close to the overnight rate, and they charge their other customers a little higher rate.
For example, if the discount rate is 0.75%, banks are likely to charge their customers relatively low interest rates. On the other hand, if the discount rate is 12% or a similar high rate, banks will charge borrowers comparatively higher interest rates.
Example of bank rates
A discount rate is the interest rate charged by a country’s central bank to other national banks to borrow funds. Nations change their bank rates to increase or restrict a nation’s money supply in response to economic changes.
In the United States, the discount rate has remained unchanged at 0.25% since March 15, 2020. In response to the global financial crisis, the Fed cut the rate by 100 basis points. The main objective was to stabilize prices, prevent rising unemployment and encourage the use of credit from households and businesses.
Among all countries, Switzerland has the lowest discount rate of -0.750%, and Turkey, known to have high inflation, has the highest at 19%.
Highest discount rate ever reported in the United States (June 1981).
What happens when the central bank raises the bank rate?
To counter inflation, the central bank may increase the discount rate. When it increases, the cost of borrowing funds increases. In turn, disposable income decreases, it becomes difficult to borrow money to buy houses and cars, and consumer spending decreases.
If the Fed cuts the federal funds rate, what happens to savings accounts?
The federal funds rate is the interest rate that banks charge each other for borrowing funds, while the discount rate or bank rate is the rate that the Federal Reserve charges commercial banks to borrow funds. A lower discount rate correlates with lower rates paid on savings accounts. For fixed rate accounts, the reduced discount rate has no effect.
What interest rate does a commercial bank pay when it borrows from the Fed?
The interest rate that a commercial bank pays when it borrows from the Fed depends on the type of credit extended to the bank. In the case of a primary credit issue, the interest rate is the discount rate. Banks that do not qualify for primary credit may be offered secondary credit, the interest rate of which is higher than the discount rate. Seasonal lending rates fluctuate with and are tied to the market.
The bottom line
A discount rate is the interest rate charged by a country’s central bank to its national banks for borrowing money. The rates applied by central banks are set to stabilize the economy. In the United States, the Board of Governors of the Federal Reserve has set the bank rate, also known as the bank rate.
Banks request loans from the central bank to meet reserve requirements and maintain liquidity. The Federal Reserve issues three types of credit depending on the financial condition of the bank and its needs. Unlike the bank rate, the overnight rate is the rate of interest that other banks charge each other for borrowing money.
In response to the global crisis, many central banks have changed their bank rates to stimulate and stabilize the economy. In March 2021, the United States responded by lowering its discount rate to 0.25%.