| Search by tag or site | Login to my blog ? Start my own blog |
Understanding The Discount Rate Vs. The Federal Funds Rate
By S. Wade Hansen, 13 August 2007 The U.S. Federal Reserve (The Fed) has been injecting billions of dollars into the financial markets to maintain liquidity amid rising interest rates. But how could interest rates be rising? Doesn't the Fed set interest rates? The answer is "Yes," but it doesn't set all of the interest rates. Let me explain. The Fed sets the Discount Rate and banks set the Federal Funds Rate. I know it seems counterintuitive. You would expect the Fed to set the Federal Funds Rate because they both have the word "federal" in them, but it is not the case. The Discount Rate is the interest rate set by the Federal Open Market Committee (FOMC). The markets vigilantly watch this number because it is the foundation interest rate upon which all other interest rates are built. This is the interest rate at which banks in the Federal Reserve System can borrow money from the Fed. However, once these banks have borrowed money from the Fed, they can lend it to other banks at whatever interest rate they want. This is where the Federal Funds Rate comes in. The Federal Funds Rate is the rate banks charge each other as they lend money back and forth. It is called the Federal Funds Rate because it is the rate banks charge to lend funds that they have received from the Federal government. The liquidity crunch that people have been talking about has been caused by a rising Federal Funds Rates, not by a rising Discount Rate. But if the Fed only controls the Discount Rate, how can it influence the Federal Funds Rate by injecting cash into the banking system? The more cash that banks have available to them, the more likely they are to lend. Banks don't make money by sitting on cash. They make money by deploying that cash and charging interest. When the Fed injects huge amounts of cash into the banking system, banks begin lending that money. The natural result of this increased lending is a lower Federal Funds Rate because banks have to compete with each other when they are lending the money they have. If Bank A wants to lend more than Bank B, it has to lower its rates, which causes Bank B to lower its rates to keep up---and the cycle goes on until both banks reach the lowest rate at which they can still turn a profit. A lower Federal Funds Rate means businesses can borrow money at a lower rate, merger and acquisition deals can find capital, and hedge funds can borrow money to leverage their accounts. The hope is that lower rates will help keep the economy growing, but only time will tell. We'll have to keep an eye on the Fed to see what else it has up its sleeve. Also, be sure to check out our blogs, videos, calendar, podcasts, pair analysis, trades, and reports at ProfitingWithForex.com |
- Can The Euro Overtake The U.s. Dollar As The World's Reserve Currency?
- Is The Eur Stuck In A Feedback Cycle?
- It May Not Be As Bad As It Looks
- Usd Outlook: Dow Plunges 366 Points
- "o Canada...
NOTE: Please click on the charts below to enlarge them if [read more]
NOTE: Please click on the charts below to enlarge them i [read more]
U.S. stock futures rebound on Citigroup results"S&a [read more]
9 Comments:
Not entirely correct- plesae do more research on who actually sets the Fed Funds Rate
The feds set the discount rate and the federal funds rate.On 8/17/07 they slashed the discount rate leaving the other @ 5.25.
How could the banks make money if they are charged a higher rate from the the fed the "discount rate", while the fed funds rate is significantly lower?
Miss leading, you got the concept totally wrong!
This article gives better explanation.
http://www.thetruthaboutmortgage.com/discount-rate-prime-rate-and-the-federal-funds-rate/
That's wrong. The discount rate is the rate that the Fed charges to lend directly to banks from federal funds, but borrowing directly from the Fed is not as common as borrowing from other banks. The Federal funds rate (the one you usually hear about) is the rate banks use to lend to each other. The Fed sets a target for the Federal Funds rate and then modifies the money supply to hit that a range of rates near that target.
I am not sure who S. Wade Hansen is, but he or she doesn't know anything about US economics. You have it all wrong! Do more homework and please revise your Web page or you risk confusing more people.
While the author should have done more homework, I wonder if others think there is nothing more laughable then an internet pissing match where people reference other website that are inaccurate.
glemwxuq mvdk iyrwxbzem oktd uxbf qhwblcv wklnq
<< My Home | TheMoneyBlogs Home