I find definitions of the federal funds rate stating that it can be
both above and below the discount rate. Which is correct?
Great question! The correct answer depends on the time period. Since
January 2003, when the Federal Reserve System implemented a “penalty” discount
rate policy, the discount rate has been about 1 percentage point, or
100 basis points, above the effective (market) federal funds rate. The
fed funds rate is the interest rate that depository institutions—banks,
savings and loans, and credit unions—charge each other for overnight
loans. The discount rate is the interest rate that Federal Reserve Banks
charge when they make collateralized loans—usually overnight—to
The federal funds market
The fed funds rate and the discount rate are two of the tools the Federal
Reserve uses to set U.S. monetary policy. Let’s start by describing
the more important of these two short-term interest rates—the
fed funds rate.
First, you should know that depository institutions are required by
the Federal Reserve to keep a certain amount of their deposits as required
reserves, in the form of vault cash or as electronic funds in
reserve accounts with the Fed.1 Over the course
of each day, as banks pay out and receive funds, they may end up with
more (or fewer) funds
than they need to meet their reserve requirement target. Banks with excess
funds typically lend them overnight to other banks that are short on
funds, rather than leaving those funds in their non-interest bearing
reserve accounts at the Fed or as idle vault cash.
This interbank market is known as the federal funds market and the effective
interest rate on daily transactions in this market is known as the federal
funds rate. As of September 2004, U.S. commercial banks reported about
$360 billion in daily average interbank loans, mostly federal funds loans—so
you can see this is a very important market for banks to make short-term
adjustments to their funding.
The Federal Reserve Bank of San Francisco publication, U.S.
Monetary Policy: An Introduction describes how the fed funds market works:
The interest rate on the overnight borrowing of reserves is called
the federal funds rate or simply the "funds rate." It adjusts
to balance the supply of and demand for reserves. For example, if the
of reserves in the fed funds market is greater than the demand, then
the funds rate falls, and if the supply of reserves is less than the
demand, the funds rate rises.
Monetary policy and the fed funds rate
For monetary policy purposes, the Federal Reserve sets a target for the
federal funds rate and maintains that target interest rate by buying
and selling U.S. Treasury securities. When the Fed buys securities, bank
reserves rise, and the fed funds rate tends to fall. When the Fed sells
securities, bank reserves fall, and the fed funds rate tends to rise.
Buying and selling securities, or open market operations, is the Fed’s
primary tool for implementing monetary policy.
Borrowing from the Fed’s Discount Window
Additionally, banks may borrow funds directly from the discount window
at their District Federal Reserve Bank to meet their reserve requirements.
The discount rate is the interest rate that banks pay on this type
of collateralized loan. On a daily average basis in September 2004,
borrowing at the discount window averaged only $335 million a day,
a tiny fraction of the $360 billion daily average for interbank loans
during that month.
The following quote from the U.S.
Monetary Policy: An Introduction,
how the discount window works and the discount rate is set:
The Boards of Directors of the Reserve Banks set these rates, subject
to the review and determination of the Federal Reserve Board… Since
January 2003, the discount rate has been set 100 basis points above
the funds rate target, though the difference between the two rates
vary in principle. Setting the discount rate higher than the funds
rate is designed to keep banks from turning to this source before
exhausted other less expensive alternatives. At the same time, the
(relatively) easy availability of reserves at this rate effectively
places a ceiling
on the funds rate.
Historical comparison: Which rate was higher?
Historically the federal funds rate has been both above and below the
discount rate, although until 2003 the funds rate typically was
the discount rate. Until January 2003, it was possible for the effective
fed funds rate to fall below the discount rate on occasion; however,
normally the funds rate exceeded the discount rate. This relationship
can be seen in the Chart 1, which plots both the interest rates and
the difference between the two rates. The effective fed funds rate
and the discount rate (in yellow before 2003 and red after 2002) compare
the level of interest rates—note that since the January 2003 change
in discount window policy the discount rate has exceeded the fed funds
The line centered on zero in the chart is the difference between the
two interest rates; it is calculated as the fed funds rate less the discount
rate. Before 2003, the line showing the difference between the two interest
rates (shown in orange) indicates that the funds rate typically was
above the discount rate by a small margin.
However, since the change to a “penalty” discount rate policy
in January 2003, the funds rate (shown in pink) has been consistently below the
bank’s reserve requirement is determined by a percentage the amount
of deposits a bank has, so each bank’s reserve
requirement is different.
For current reserve requirements, please see Reserve Requirements of
Instruments of the Money Market. (1998) Federal
Reserve Bank of Richmond. http://www.rich.frb.org/pubs/instruments/
Selected Interest Rates (H.15 Release). Board of Governors of the Federal
Reserve System. http://www.federalreserve.gov/releases/
U.S. Monetary Policy: An Introduction. (2004) Federal Reserve Bank of