Academic journal article Economic Commentary (Cleveland)

The New Discount Window

Academic journal article Economic Commentary (Cleveland)

The New Discount Window

Article excerpt


Federal Reserve Bank of Cleveland

For the past 20 years, the Federal Reserve Banks have made discount window loans to depository institutions (DIs) at interest rates that were below the rate at which DIs would lend to each other in the federal funds market (see figure 1). Now, that has changed. On January 9, 2003, the Reserve Banks raised their basic discount rates by 150 basis points to a level higher than the federal funds rate. This represented no change in the stance of monetary policy, but rather one of operational procedure. The intention is to rely on an above-market discount rate instead of the administrative devices of 12 Federal Reserve Banks (such as lending guidelines) to ration borrowing at the discount window. If it works-and so far it has (see inset on figure 1)-the discount rate should become a ceiling on the level of the federal funds rate, the effect of which will be to keep the actual federal funds rate closer to the target. Whether the discount rate actually will act as a ceiling, however, will only emerge from experience during periods of substantial reserve shortage such as those that drove the funds rate far above the discount rate in the past.

This Commentary looks at the changes in the behavior of DIs and the 12 Federal Reserve Banks that will be necessary to ensure the desired realignment of rates. In general, three changes must take place. The first seems assured: Reserve Banks actually must set their basic discount rates above the Federal Open Market Committee (FOMC) target for the federal funds rate. Initially, rates have been set at a 100 basis-point spread above the funds rate target. The Federal Reserve System has indicated it intends to maintain a significant positive spread between these two official rates, although the size of the spread might need to be varied.

Two other important changes must take place if the actual market federal funds rate is to remain below the discount rate: Depository institutions must shed their reluctance to borrow at the discount window, and Reserve Bank lending officers must adopt a new approach to lending. Revisions to Federal Reserve Regulation A, also effective on January 9, should facilitate these changes. A comparison of the old and new discount windows shows how those revisions enable-but don't guarantee-the required changes in borrower and lender behavior.

* Why the Discount Rate Used to be Lower

Under the old discount window arrangement, the discount rate on adjustment credit typically was below the funds rate, sometimes by a very substantial margin. (Adjustment credit was the most basic of the three types of credit provided.) This was possible only because DIs were reluctant to borrow at the discount window and Reserve Banks operated under Board of Governors regulations that guarded against arbitraging the low discount rate. Otherwise, the funds rate would have fallen to the level of the discount rate and generated an inconsistency between the institutional structure of the Federal Reserve System and the structure of the market for bank reserves.

To understand this potential inconsistency, recognize that the Banking Act of 1935 lodges monetary policy authority in the United States in the Federal Open Market Committee. The FOMC includes the seven members of the Board of Governors, the president of the Federal Reserve Bank of New York, and, on a rotating basis, four presidents of the remaining 11 Reserve Banks. Policy authority is exerted mostly through open market operations. These purchases or sales of securities add or drain bank reserves, creating downward or upward pressure on the cost and availability of money and credit, which can be indexed by the level of the federal funds rate.

Like open market operations, an increase or decrease in lending at the discount window also adds or drains bank reserves. The level of the discount rate at which a Reserve Bank will lend is set by its board of directors, subject to "review and determination" by the Board of Governors. …

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