Fed Discount rate vs Fed Futures rate

Fed announced a cut in the discount rate yesterday from 6.25% to 5.75%. The idea is to calm the financial markets and Fed even released a statement for the motive which shows that Fed is now concerned over growth. The statement says growth has so far been at a moderate pace but downside risks remain. Financial Markets are very important after all.

One might wonder why the discount rate? What is it? This is not Fed’s benchmark rate – Fed Funds rate. What is the difference between the two?

As usual WSJ Blog comes to rescue. It explains Fed Futures rate as:

The fed funds rate is the rate banks with excess reserves charge when they lend money to other banks overnight. It moves according to a traditional supply-demand path. When there are more institutions looking to borrow than lend, the rate goes up. When there are more lenders, it goes down. The Federal Reserve sets a target for this interest rate, and the Trading Desk at the Federal Reserve Bank of New York adds or drains funds to keep the rate near its target, which is now 5.25%

Each morning, reserve forecasters at the New York Fed and at the Board of Governors in Washington compile data on bank reserves for the previous day and make projections of factors that could affect reserves for future days. They consult with Treasury Department officials, and then the Trading Desk officials in New York make a plan for the day. The plan is then reviewed by at least one voting FOMC member.

And the discount rate as:

The discount window is a channel for banks and thrifts to borrow directly from the Fed rather than in the markets. Until a few years ago, the discount rate was set below the fed funds rate and loans were subject to numerous conditions.

Banks were reluctant to access the window because it was associated with a stigma usually reserved for distressed banks. A few years ago the Fed overhauled the discount window to try and alleviate that stigma; the rate was then set one percentage point above the funds rate and subject to far fewer conditions. In spite of that, discount window borrowing has remained paltry.

The difference:

Open market operations, under which the Fed buys and sells securities to adjust the supply of bank reserves and keep the federal funds rate on target, primarily operate through a network of primary dealers, some of whom are large banks. Thus, they have only indirect impact as a supply of funds for the thousands of banks that are not active in the money market. The discount window, however, is available to any bank or thrift, and the terms are easier than for fed funds loans. For example, banks may submit mortgage loans, including subprime loans that aren’t impaired, as collateral, and many probably will.

To draw similarities, FFR is like the reverse repo and repo rates of RBI and Discount rates are like the Bank rate of RBI.

Discount rate cut has increased the probability of cut in FFR when Fed meets on Sep 18 to decide on latter.  Data from CBOT tells me that Fed Futures rate for Sep closed y’day at 95.07 implying a Fed Funds Rate of 4.93%. So rate cut has been factored in Sep. Dec Future closed at 95.45 implying a FFR of 4.55% a cut of 75 bps from current FFR of 5.25%.

Read the Economists’ reaction to the same.

WSJ blog provides further clarity and says the impact may not be as much because the discount window is only open to select institutions.

This is excellent stuff from WSJ Blog. Keep up the good work.

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5 Responses to “Fed Discount rate vs Fed Futures rate”

  1. Assorted Links « Mostly Economics Says:

    […] Fed has cut its benchmark rate by 50 bps and discount rate by 50 bps (differnce between the two is here). As it was the most awaited event, expect a lot of blogs on the subject. WSJ Blog points to […]

  2. Monetary Policy and Stock Market « Mostly Economics Says:

    […] that it is important to distinguish between expected and unexpected changes in interest rates (the fed funds rate) . If the actual change is as the market expects, then financial markets would have already priced […]

  3. Assorted Links « Mostly Economics Says:

    […] Fed cutthe fed funds rate and the discount rate by 25 bps in the FOMC meeting(see the difference here) . FFR is now 4.5% and discount rate is 5%. Only Koenig (Kansas City Fed President) dissented. WSJ […]

  4. Assorted Links « Mostly Economics Says:

    […] 1. Fed cut its benchmark rate and discount rate by 25 bps (the difference between the two is here). WSJ Blog points to the economists’ reaction. It has also analysed the 12 Fed […]

  5. Assorted Links « Mostly Economics Says:

    […] move lowered both fed funds rate and discount rate by 75 bps (difference between the two is here). I juts don’t know what is really going on in US. Fed and policymakers are surely seeing […]

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