Open, Says the Fed
Subject Federal Funds Rate
Topic Monetary Policy
Key Words Federal Reserve, Discount Rate, Federal Funds Rate
News Story

Commercial banks can occasionally find themselves short of reserves. Banks borrow approximately $60 billion on an average day, and more if there is a financial crisis. Another alternative is for banks to borrow directly from the Federal Reserve, although the Fed frowns on repeat borrowers. The Fed is proposing a change in the way that it loans reserves to member banks. The Fed proposes to allow greater access to loans in exchange for higher interest charges.

One of the functions of the Federal Reserve is to act as a banker's bank. Should a bank find itself short of funds, it can go the "discount window" and borrow from the Fed. Banks pay interest on the funds they borrow and the rate they pay is called the "discount rate." There is another price that banks sometimes pay if they borrow from the Fed. If a bank goes to the window too often it invites a close inspection of its financial management practices. This is why the Fed is termed the lender of last resort.

After the September 11 terrorist attacks, the Fed wanted to ensure that financial institutions had all the funds they needed, so it invited banks to borrow as much as they wanted. Taking advantage of this opportunity, banks borrowed over $45 billion on September 12. This act not only provided needed liquidity, but also reduced the volatility in the Federal Funds market that typically accompanies a financial crisis.

Experience with this policy no doubt contributed to the Fed's latest proposal that banks have open access to the discount window. Under this policy, borrowing will be determined by the market rather than desire to avoid stigma. Bank borrowing will no longer invite an audit; instead banks will pay a premium of 1 percent above the Federal Funds rate. If a bank is in financial difficulty and needs to borrow heavily, the premium would rise to 1.5 percent.

In announcing this proposal, the Fed emphasized that this was not a change in monetary policy. The discount rate, which has been at or below the Federal Funds rate, would simply be set above it.

(Updated June 1, 2002)

1. How is the discount rate used as an instrument of monetary policy? The Federal Funds rate?
2. What is the primary instrument of monetary policy? How does it operate?
3. The Fed argues that this proposal would reduce stabilize rates in the Federal Funds market. Do you agree or disagree? Explain your answer.
Source John M. Berry, "Proposal Would Remove 'Stigma' From Discount Window," The Washington Post, May 18, 2002.

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