I find definitions of the federal funds rate stating that it can be both above and below the discount rate. Which is correct?

September 1, 2004

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 depository institutions.

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 supply 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, describes 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 could vary in principle. Setting the discount rate higher than the funds rate is designed to keep banks from turning to this source before they have 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 above 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 (in black) 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 rate.

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 discount rate.

Chart 1


1. A 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 Depository Institutions at: http://www.federalreserve.gov/monetarypolicy/reservereq.htm.


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 San Francisco.