Discount Rate (Federal Reserve)

Which statement correctly distinguishes the discount rate from the federal funds rate?

1. A.The discount rate is charged by the Federal Reserve on loans to depository institutions, while the federal funds rate is the market rate banks charge one another for overnight reserves.Correct. One is a Fed-to-bank administered rate; the other is a bank-to-bank market rate the FOMC targets.
2. B.The federal funds rate is set administratively by the Federal Reserve, while the discount rate is determined by the market.This reverses which rate is set and which is targeted.
3. C.Both rates apply exclusively to loans between commercial banks and their corporate customers.Neither rate applies to bank lending to corporate customers.
4. D.The discount rate is the rate at which the Treasury issues short-term bills at auction.That is the Treasury bill discount yield, an unrelated concept.

Why: The discount rate is the interest rate the Federal Reserve charges depository institutions that borrow directly from the Fed at the discount window, and it is set administratively by the Federal Reserve. The federal funds rate is the rate at which depository institutions lend reserve balances to one another overnight; it is a market-determined rate that the Federal Open Market Committee targets rather than sets by decree. Borrowing at the discount window is between a bank and the Fed, while federal funds borrowing is between two banks.

A regional bank that is short of reserves borrows directly from its Federal Reserve Bank rather than from another commercial bank. The discount rate is:

1. A.The overnight interbank rateThis is the federal funds rate, the rate banks charge each other for overnight reserves. The discount rate is what the Fed itself charges banks that borrow directly from it, so the lender is different.
2. B.The rate the Fed charges banks to borrowCorrect - the Fed's lending rate to banks.
3. C.The 30-year mortgage rateMortgage rates are set in the consumer lending market and reflect long-term yields plus credit and prepayment spreads. Fed policy influences them indirectly, but they are not a rate the Fed sets.
4. D.The rate banks charge their best customersThis is the definition of the prime rate. Prime is set by commercial banks for their most creditworthy borrowers; the discount rate is set by the Fed for loans it makes to banks.

Why: The discount rate is the interest rate the Fed charges member banks for short-term loans.