What Is The Fed’s Discount Rate And Does It Affect Housing?

By Bridgette Fanucchi Published Sep 5, 2007 11:24 am Updated Feb 3, 2015 11:24 am

The Federal Reserve rate cut of last month failed to stop the bleeding in the U.S. stock market. That’s because the Fed cut the ‘discount’ rate, not the federal funds interest rate. What’s the difference and how will housing be impacted?

You won’t find the answer on financial news sites. They talk in jargon. So here’s a little lesson in American federal money flow management.

The Federal Reserve is the bank of the federal government and the guardian of the U.S. economy, and as such, regulates monetary and credit policies such as buying and selling securities, setting the cost of credit (interest rates,) how much money is available to banks for borrowing, and how fast and at what rates the money has to be repaid. The idea behind the Federal Reserve is to keep things running smoothly, so banks that are members of the Fed are federally insured, which is reassuring to depositors like you and me.

To accomplish the flow of money, The Fed operates 12 regional banks, who monitor the economy and loan money to ‘member’ depository banks — (member FDIC.)

There are two ways banks can borrow money using Fed-insured funds. They can borrow money directly from the Fed using the ‘discount’ rate, or they can borrow from each other using the ‘federal funds’ interest rate. Both are short-term or overnight rates.

The discount rate is designed to improve liquidity for the banks themselves. The federal funds interest rate is designed to improve or limit liquidity or access to credit for consumers.

Because the Fed can’t dictate what happens in the open market or between banks, the Fed will issue a ‘target’ rate for federal funds, which most banks stick close to. They can then charge consumers whatever they feel they can get away with in the form of credit card interest rates, mortgage interest rates, car loans and so on.

If the economy is sluggish and consumers aren’t spending, the Fed will lower target rates to encourage banks to lower the cost of borrowing. If the economy is heating up more than about three percent of annualized growth, inflation is a danger, and Fed will make credit more expensive to slow things down.

In August, the Fed cut its discount rate by 50 basis points, from 6.25% to 5.75%. Since the discount rate is used by banks for their own liquidity, it’s considered a ‘secondary’ rate because it doesn’t impact consumers directly. The lowering of the discount rate is viewed by many in the economy as a largely symbolic gesture that the Fed is acknowledging that the economy might be slowing to the point that it will consider a cut in the federal funds rate so that consumers can benefit.

The Federal Reserve can decide at any time to raise or lower the cost of the discount rate to banks, but raising or lowering federal funds rates is done by the Federal Open Market Committee (FOMC), composed of the Board of Governors and the 12 Reserve Bank presidents, although only five of those can vote at any single meeting. The Committee meets eight times annually to whether or not to raise key interest rates – the discount and federal funds rates.

Last month, the FOMC had just met and decided not to raise or lower federal funds rate, leaving the 5.25% funds rate in place for the ninth meeting in a row. But after the Fed cut discount rates, many pundits believe that the next time the Fed meets, in September, the FOMC will vote to lower key interest rates by 25 to 50 basis points.

Meanwhile, what housing consumers can look forward to is a general calming of the markets with less panic than has been shown lately.

Mortgage interest rates, in the face of expanding liquidity, are likely to drift downward, which will make buying a home more affordable in the short-term.