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What Is the Federal Discount Rate?

Federal Reserve Discount Rate Explained
Sulaiman Abdur-Rahman
Sulaiman Abdur-RahmanUpdated March 16, 2022
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The federal discount rate is the interest rate charged when any Federal Reserve Bank lends money to a commercial bank, credit union, or thrift institution through the discount window. The discount window allows depository institutions to borrow money from their regional Federal Reserve Bank whenever they need quick cash.A depository institution pays this discount rate and loan principal as a condition of borrowing credit from one of the Fed’s regional banks. The Federal Reserve has 12 regional banks, and all of them can offer loans to a depository institution experiencing low cash on hand.

How the Federal Discount Rate Works

The federal discount rate works by requiring depository institutions to pay interest on any money they may borrow from a Federal Reserve Bank. Depository institutions include commercial banks, credit unions, and thrift institutions. This interest rate is predetermined and fixed.

Who Sets the Discount Rate and How?

The Federal Reserve sets the discount rate through a process mandated by federal law. The Federal Reserve Act requires the directors of the 12 Federal Reserve Banks to establish the discount rate subject to final approval by the Fed’s Board of Governors.The Board of Governors reviews and determines the federal discount rate from time to time. The Board of Governors in January 2022, for example, kept the federal discount rate at 0.25% for primary credit loans after nine out of 12 Federal Reserve Bank directors voted to maintain that rate.As the U.S. central bank, the Federal Reserve can raise, lower, or maintain the federal discount rate. The Fed lowered the discount rate to 0.25% in response to the COVID-19 pandemic in March 2020 and consistently voted to maintain that rate throughout 2020 and 2021.The Federal Reserve may consider raising the federal discount rate in 2022 to help combat inflationary price increases of goods and services.

Types of Federal Discount Rates

There are three types of federal discount rates:

Primary Credit Discount Rate

The primary credit discount rate is the rate of interest that a Federal Reserve Bank charges when offering primary credit loans to eligible depository institutions.All depository institutions with sound financial conditions are generally eligible for primary credit. This is the Fed’s main discount window program.

Secondary Credit Discount Rate

The secondary credit discount rate is the rate of interest that a Federal Reserve Bank charges when offering secondary credit loans to depository institutions.Secondary credit loans are available to any bank, credit union, or thrift institution that does not qualify for primary credit. The secondary credit discount rate is generally higher than the primary credit discount rate.

Seasonal Credit Discount Rate

The seasonal credit discount rate is the rate of interest that a Federal Reserve Bank charges when offering seasonal credit to eligible depository institutions. Small depository institutions may qualify for seasonal credit if they encounter seasonal swings in their loans and deposits. The seasonal credit discount rate is a floating rate based on market rates.

Federal Discount Rate vs Federal Funds Rate

The federal discount rate on primary and secondary credit is determined by the Federal Reserve directly, while the federal funds rate is set by market conditions influenced indirectly by Fed action. Below is a table comparing the federal discount rate vs. the federal funds rate:
Federal discount rateFederal funds rate
The Federal Reserve sets this rate directly through its Board of Governors for primary and secondary credit loansThe Federal Reserve doesn’t directly control this rate
Any Federal Reserve Bank director may recommend changes to this rate for primary and secondary credit loansThe Federal Open Market Committee of the Federal Reserve sets a target range for this rate
Federal Reserve Banks charge this rate when lending money to depository institutionsDepository institutions charge this rate when lending money to other depository institutions
All discount window loans are fully secured by collateralLoans subject to this rate may be unsecured

How the Discount Rate Interacts With Monetary Policy

The Federal Reserve sets U.S. monetary policy and uses the discount rate as one of its tools for promoting a stable banking system. Changes to the discount rate can influence the monetary supply, and changes in the monetary supply can influence inflation.The Fed can discourage banks from borrowing at the discount window by raising the discount rate. This can rein in the available supply of money and help bring inflation under control. Lowering the discount rate, meanwhile, can encourage borrowing at the discount window, which may pump more money into the economy at the risk of fueling faster inflation.Under federal law, the Federal Reserve’s monetary policy objective is to promote the goals of maximum employment, stable prices, and moderate long-term interest rates in the U.S. economy. Small business owners can help spur job creation and economic growth by applying for business loans and spending the money on business needs.Minimal discount window lending generally occurs under normal conditions but can surge during times of economic crisis. For example, more than 900 depository institutions borrowed primary credit from a Federal Reserve Bank in the first six months of the COVID-19 pandemic. The Federal Reserve’s discount window programs can help depository institutions meet demand for all business loan types during times of economic crisis when banks might be less inclined to lend to one another. The Fed’s flexibility as a lender of last resort for banks can help support the banking system and U.S. economy at large.

The Takeaway

Depository institutions may experience cash shortfalls on any given day. Federal Reserve Banks can help those institutions by offering short-term loans through a discount window program. The Federal Reserve sets the discount rate on those loans to help support the U.S. economy.

3 Small Business Loan Tips

Here are three small business loan tips:
  • Online lenders generally offer fast application reviews and quick access to cash. Conveniently, you can compare small business loans by filling out one application on Lantern by SoFi.
  • Traditionally, lenders like to see a business that’s at least two years old when considering a small business loan.
  • If you need to borrow money to cover seasonal cash flow fluctuations, a business line of credit, rather than a term loan, provides the flexibility you likely need.

Frequently Asked Questions

How is the federal discount rate set?
What happens when the Federal Reserve raises the discount rate?
Is the federal discount rate an interest rate?
Photo credit: iStock/Toshe_O

About the Author

Sulaiman Abdur-Rahman

Sulaiman Abdur-Rahman

Sulaiman Abdur-Rahman writes about personal loans, auto loans, student loans, and other personal finance topics for Lantern. He’s the recipient of more than 10 journalism awards and served as a New Jersey Society of Professional Journalists board member. An alumnus of the Philadelphia-based Temple University, Abdur-Rahman is a strong advocate of the First Amendment and freedom of speech.
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