In 2003, the Fed made significant changes to its discount window. Do your textbook and your lessons about the Fed reflect these changes?
"Discount window" is the term used to describe the process by which banks can borrow from the Federal Reserve when they are temporarily short of funds. For more than 20 years, the discount rate, the interest rate at which banks could borrow from the Fed, was below the Federal Open Market Committee's (FOMC's) federal funds rate target. (See the Side Bar for basics on both the discount window and the federal funds market.) Since January 9, 2003, the discount rate has been set 1 percent above the target. Why has the Fed made these changes, and what implications do they have for how we teach students about the Federal Reserve and monetary policy?
Economics textbooks explain that the discount rate is one of the three tools of monetary policy. (The other two tools are the reserve requirement and open market operations.) Prior to January 9, 2003, the "discount rate" referred to the interest rate charged on loans made through a Federal Reserve discount window program called "adjustment credit." On January 9, 2003, the adjustment credit program was replaced with what is officially known as "primary credit." Although the media and textbooks continue to refer to the Fed's "discount rate," that term now refers to the lending rate for "primary credit." (See the sidebar for a comparison of the old and new discount window lending programs.) More important, the Fed's raising of the discount rate from 0.75 percent on January 8, 2003, to 2.25 percent on January 9, 2003, did not represent a tightening of monetary policy. (See figure.) Rather, financial markets understood that the Fed was simply restructuring its lending programs to banks, and other interest rates did not rise when the Fed changed what many people are still calling the discount rate.
The Fed adopted the new discount window program for three primary reasons. First, with the discount rate above the federal funds rate target, the discount rate can now serve as a ceiling on the level of the federal funds rate and help to keep the actual federal funds rate closer to the FOMC's target in times of financial stress. Second, under the new discount window provisions, depository institutions will likely be less reluctant to borrow at the discount window and can re-lend the funds they borrow. Third, the Fed now has significantly less administrative burden because the new discount rate provides price-rationing while previously, Federal Reserve officials used administrative procedures to limit (that is, ration) discount window loans requested by banks.
Before 2003, Reserve Bank officials rationed use of the discount window by establishing rules that stated that depository institutions should not borrow too frequently, should not re-lend discount window credit in the market, and should exhaust alternative sources of funding before borrowing from the Fed.
Under the new system, financial institutions are likely to seek credit elsewhere first because the discount rate will usually be higher than the prevailing federal funds rate. However, when the federal funds rate spikes above the discount rate, as can happen in times of financial stress, financial institutions are now likely to borrow at the discount rate rather than continue to seek funds in the market. The substitution from the federal funds market to the discount window will provide a safety valve for the federal funds market and an upper ceiling for the federal funds rate roughly equal to the level of the discount rate. When the federal funds rate begins to rise above the discount rate, some banks will borrow at the discount window, then re-lend funds to other banks that need them. The new discount window program will reduce the need to use open market operations to fine tune the supply of bank reserves in the face of shocks in the federal funds market.
Before 2003, financial institutions were restricted from borrowing at the discount window and then re-lending those funds in the federal funds market. If it weren't for these restrictions, as banks borrowed at the discount window and re-lent those funds in the federal funds market, the federal funds rate would have been bid down until it equaled the discount rate. Under the new program, financial institutions are allowed to re-lend funds obtained at the discount window.
Now that the discount rate is significantly above the federal funds rate, financial institutions will be unlikely to borrow at the discount window too frequently, since they usually will be able to obtain cheaper credit in the federal funds market. Likewise, the requirement under the pre-2003 discount window that financial institutions demonstrate that they have exhausted alternative sources of credit has been lifted under the new discount window program, since it is unlikely that financial institutions would seek to borrow at a premium from the discount window unless they have exhausted cheaper alternatives. Therefore, under the new program, it is the discount rate itself that provides price-rationing and makes administrative rationing by Fed officials unnecessary.
Depository institutions' reluctance to borrow at the discount window grew over time. When the Federal Reserve System was established in 1913, the discount window was the primary vehicle of monetary policy in terms of changing the supply of credit in the economy. During the 1920s, the emergence of the federal funds market, the discovery of how open market operations could alter interest rates and credit availability, and the sentiment that banks should borrow from other banks when in need of additional funds, all contributed to infrequent borrowing at the discount window by depository institutions. Indeed, depository institutions came to fear they would be perceived as unsound if they borrowed at the discount window. In addition, since Fed officials administratively rationed discount window borrowing, depository institutions feared that if they borrowed at the window, they might "use up" an implied limit on the number of times they could borrow from the Fed.
Andrew T. Hill, Ph.D.