The Fed’s Discount Rate Increase: The Context

To understand yesterday’s increase in the Fed’s discount rate, one must review its context in recent history. The Fed’s first policy action during the mounting financial crisis in the fall of 2007 was a half percentage point reduction in its discount rate from 6.25 percent to 5.75 percent. While this action surprised most observers who had grown accustomed to focusing only on the Fed’s target Federal Funds rate, it made sense because the discount window and the discount rate were the tools of choice in dealing with a financial crisis. In fact, the Fed was established as a result of the Panic of 1907 and the discount mechanism and rate were the only tools of monetary policy given to the Fed in the Federal Reserve Act. Changes in reserve requirements and open market operations came later.

In the years immediately preceding the latest financial crisis, the Fed worked to restore the discount rate as a penalty rate somewhat higher than the Federal Funds rate. They had decided that the differential should be one percentage point. Hence, the Fed entered the crisis with the Federal Funds target rate at 5.25 percent and the discount rate at 6.25 percent. The logic of a penalty discount rate is that the Fed prefers to let the rate structure ration Federal Reserve credit rather than having to do so administratively.

It has long been against the rules for banks to engage in arbitrage by borrowing at the discount rate and lending in the Fed Funds market at a higher rate. Having the discount rate higher meant that, in normal times, borrowing in the Federal Funds market would be less expensive than borrowing from the Fed. However, during unusual periods of reserve shortages in the banking system, the Federal Funds rate would be bid up above the discount rate and trigger borrowing from the Fed.

Those two options for bank borrowing make a big difference in their economic consequences. Borrowing from other banks in the Fed Funds market does not create new reserves for the banking system. It just transfers existing reserves among banks. Borrowing at the discount window, on the other hand, creates new reserves for the banking system and increases the system’s capacity for expansion.

When the Fed reduced the discount rate in September 2007 and left the Federal Funds rate unchanged, it was deliberately increasing the likelihood that banks would shift their borrowing to the Fed and trigger reserve and monetary expansion. By reducing the discount rate, the Fed intentionally abandoned the traditional one percent differential in order to deal with the crisis. But this reduction was never intended to be permanent.

Yesterday’s quarter point increase in the discount rate from one-half to three-quarters of a percent was the Fed’s first step in restoring that desired relationship. Unless the Fed has changed its mind about one percentage point being the desired spread in normal times, the discount rate will be raised again relative to the Federal Funds rate. That can be done by making one or two more discount rate only moves, or by raising both rates together with the discount rate going up more. If you consider the present Federal Funds rate to be a quarter of a percentage point, the preferred discount rate will be one and a quarter percentage points. When the target Federal Funds rate is raised to half a percentage point—around June is my guess—the discount rate will probably be raised by a half point rather than a quarter point. The one percentage point differential is likely to be restored, but it may not be fully restored until the Fed has made two or three more moves.

The background described above suggests that yesterday’s action should not be taken as a tightening of monetary policy so much as the beginning of a return to the preferred relationship between the Fed’s two policy rates. Nevertheless, it will have real consequences at the margin by shifting bank borrowing further away from the Fed and toward the market. Borrowing in the short-term market will still be relatively inexpensive, but it won’t result in as much monetary expansion. I’d call yesterday’s change three quarters technical and one-quarter policy.

Comments (8)

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  1. [...] point differential between the Federal Funds target rate and the discount rate. From McTeer’s blog: Yesterday’s action should not be taken as a tightening of monetary policy so much as the [...]

  2. Tony Pallotta says:

    Mr. McTeer – why do you anticipate the Fed Funds rate to be moved in June? Would this be part of a modest move up to say 1% and then hold for an “extended period” until the labor market begins to show sustainable job creation? Will this move come prior to reverse repos and interest on reserves held at the fed? From what I have read with so much excessive reserves the Fed Funds rate may not have much affect within the credit market.

    With today’s CPI data including a drop in core inflation appears to be somewhat tame.

    Thank you,

    Tony
    Denver CO

  3. [...] – Fed’s discount rate hike has more to do with technical reasons than a policy shift, former Dallas Fed president Bob McTeer says. [...]

  4. Bob McTeer says:

    Tony:

    June may be a little early. However, a while back Larry Kudlow challenged me to “pick a month,” and, as usual with double-dog dares, I got caught up in the moment. A similar thing happened a couple of years ago on a Forbes Investor Cruise. I was challenged to make a Dow call for the end of 2009 and I picked 11,000. I immediately regretted it, but it turned out pretty well. On principle, I try not to constantly update my forecasts, which unfairly guarantees accuracy.

    The Fed won’t be able to move the Federal Funds target rate until it removes the “considerable period” language; so, that one won’t be much of a surprise.

  5. T Le says:

    Thank you for your explanation on why the Fed is doing this. Do you think that the Fed will continue to hike discount and Fed fund rate instead of having to do reverse repo and interest on reserves and that these are just academic talk?

  6. Sunshine says:

    When forecasting, pick a number or pick a date but never pick both.

  7. I think this is great opportunity for all. Don’t miss it guy’s…

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