Difference between discount rate and funds rate
moneyrelations :: Sep.19.2007
Yesterday, the US Federal Open Market Committee (FOMC) met and cut both the discount and federal funds rate by half a percent to 5.25 and 4.75% respectively. The streets rejoiced. Hallelujah! But if you ask any person on said streets, can they explain what exactly are these two rates? What’s the difference?
Let me take a stab at it through layman’s terms:
The discount rate is the interest rate charged to banks who borrow from the Federal Reserve Bank.
I then cheated and looked at what Investopedia had to say:
This type of borrowing from the Fed is fairly limited. Institutions will often seek other means of meeting short-term liquidity needs. The Federal funds discount rate is one of two interest rates the Fed sets, the other being the overnight lending rate, or the Fed funds rate.
Onto the federal funds rate. Again from Investopedia:
The interest rate at which a depository institution lends immediately available funds (balances at the Federal Reserve) to another depository institution overnight.
Okay, ungeek the speak. By law, depository institutions (lets say banks because it’s easier to type) need to keep a percentage of funds in reserve. If they don’t have enough funds, they borrow from other banks with excesses to meet this overnight requirement at a certain interest rate. This is the federal funds rate.
When the Fed cuts rates, the markets generally cheer as the cuts eventually trickle down to us common folk to encourage spending and economic growth. I’m sure the next few days will be filled with opinions on whether the Fed did the right thing for the long term. I hope you enjoyed this explanation as it relates to stock market for beginners!
Definitions, In the news ::
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