The discount rate is the interest rate the Federal Reserve Banks set on secured overnight loans to depository institutions. The Federal Reserve Bank of New York's discount rate was 1.00 percent from August 1937 to January 1948. That's still the lowest discount rate.
The discount rate is one of three monetary policy tools used by the Federal Reserve to implement monetary policy. The other two are the federal funds interest rate and changes in reserve requirements. The Fed targets the federal funds rate; this is its most important monetary policy tool. The discount rate is typically adjusted to complement open market operations and monetary policy. Today reserve requirements are rarely adjusted for monetary policy purposes.
The discount rate dropped to 1.25 percent in December 2001. (See Chart.) The Board of Directors of the 12 Federal Reserve Banks lowered the discount rate from 1.50 percent to 1.25 percent between December 11 and December 13, 2001. The last time the discount rate was lower than 1.25 percent was in January of 1948, when it was raised from 1.00 percent to 1.25 percent.
A new Fed proposal may change how the discount rate is set. Under the proposal the Federal Reserve would set the discount rate above the federal funds rate. Using the Fed's current operating procedures, the discount rate normally is 25 to 50 basis points (0.25 to 0.50 percent) below the federal funds rate. The new proposal would set the discount rate above the federal funds rate target and streamline the eligibility requirements for borrowing to eliminate some of the nonpecuniary costs that presently make banks reluctant to borrow from the discount window. For additional detail please see, "Setting the Interest Rate," by Milton Marquis, FRBSF Economic Letter, Number 2002-30, October 11, 2002.