THE RELATIONSHIP BETWEEN THE DISCOUNT RATE AND THE FEDERAL FUNDS RATE UNDER THE FEDERAL RESERVE’S POST-OCTOBER 6, 1979 OPERATING PROCEDURE*
Alfred Broaddus and Timothy Cook
Federal Reserve bank directors, who are respon- the Fed bought or sold U. S. securities in the sible for establishing the discount rate at their re- open market to move the funds rate back to the spective banks, subject to the approval of the Board desired level. In doing so it necessarily increased or of Governors, naturally have a strong interest in the decreased the outstanding level of nonborrowed re- likely effect of discount rate changes on the Federal serves-that is, the level of reserves held by banks funds rate. Under the post-October 6, 1979, Federal other than those borrowed at the discount window- Reserve operating procedure, changes in the discount but the magnitude of these changes received little rate have typically been followed by changes in the attention. Federal funds rate in the same direction and of The key point to keep in mind about the pre- roughly the same magnitude, under usual condi- October 6 procedure is that under this procedure tions where the funds rate is above the discount rate. the Fed fixed the funds rate within very narrow For example, an increase in the discount rate of one limits in the short run. In this situation, sustained percentage point has typically been followed by changes in the spread between the funds rate and the about a one percentage point increase in the funds discount rate were possible following a change in the rate. This relationship between the two rates differs discount rate. To see this, assume that the funds from their relationship in the period before October 6, rate was above the discount rate. When the Fed 1979, when changes in the discount rate did not changed the discount rate, the change affected the generally have a significant impact on the funds rate. spread between the funds rate and the discount rate, The purpose of this article is to explain the basic and the change in the spread, in turn, affected the difference between the procedures used in the two proportion of its total reserve need the banking sys- periods and to show how this difference has affected tem borrowed at the discount window. (A reduction the relationship between the funds rate and the dis- in the discount rate increased borrowing and vice- count rate. More broadly, the article attempts to versa.) If nothing else had happened, this change in clarify the role of the discount rate in the overall borrowing would have affected activity in the Federal conduct of monetary policy in the post-October 6 funds market and therefore would have affected the operating regime. funds rate. Under the old procedure, however, the Fed varied the supply of nonborrowed reserves to 1. The Pre-October 6 Procedure whatever extent was necessary to keep the funds rate Before October 6, 1979, the Federal Reserve at the desired level. In brief, under the old pro- sought to achieve its money supply objectives by cedure, changes in the discount rate affected ( 1) the manipulating the Federal funds rate directly through spread between the funds rate and the discount rate open market operations. Under this procedure the and (2) the allocation of total reserves between bor- Fed first chose a desired funds rate level believed rowed reserves and nonborrowed reserves. They did to be consistent with the money supply objective. not significantly affect the funds rate. If the actual funds rate deviated from this level, The following example may help to clarify these points. Suppose that under the old procedure the Fed was fixing the funds rate at 12 percent and * This paper was prepared as part of a staff presentation the discount rate was 10 percent. Suppose further to the Board of Directors of the Federal Reserve Bank of Richmond on September 9, 1982. that at this two percentage point spread, commer-
12 ECONOMIC REVIEW, JANUARY/FEBRUARY 1983 cial banks in the aggregate were borrowing $2 billion for nonborrowed reserves for a given statement week at the discount window. If the Fed then raised implies a particular level of borrowed reserves in that the discount rate to 11 percent, thereby reducing week. Because, as noted above, the demand for bor- the spread from two percentage points to one point, rowed reserves depends on the spread between the the interest cost advantage of borrowing temporarily funds rate and the discount rate, the implied level of at the discount window instead of buying funds in borrowing in a particular statement week will be con- the funds market would diminish. As a result, banks sistent with a particular, spread. Therefore, under would reduce their borrowing at the window and the new procedure the choice of a nonborrowed re- increase their purchases of funds in the. Federal funds serve target strongly influences the spread between market. The increased purchases of Federal funds, the funds rate and the discount rate in the current in turn, would put upward pressure on the funds statement week.3,4 It follows that if the discount rate. In order to keep the funds rate at its desired rate is changed, the funds rate must change by a level, the Fed would supply additional nonborrowed roughly equal amount to re-establish the spread reserves through open market operations. The final between the funds rate and the discount rate that is result would be a reduction in the spread between consistent with the borrowing level implied by the the funds rate and the discount rate and a reduction nonborrowed reserve target. If the implied level of in the proportion of the banking system’s total re- borrowing changes significantly in subsequent weeks, serve need supplied through the window, but no both the spread and the funds rate will change. Alter- significant change in the funds rate. natively, if the implied level of borrowing remains roughly the same, both the spread and the new level 2. The Post-October 6 Procedure of the funds rate will be maintained. It is important to understand what the October 6 Consider again the above example of a 12 percent change did and did not involve. The change was funds rate and a 10 percent discount rate. Assume not a move to a procedure in which the Fed controls further that the level of borrowing implied by the the money supply by manipulating the supply of total nonborrowed reserves target is $2 billion. Suppose reserves. The Fed cannot manipulate the supply of again that the Fed raises the discount rate to 11 total reserves in the current statement week under percent. Initially, the increase in the discount rate present arrangements due to the present system of would again reduce the spread between the funds lagged reserve accounting. With lagged reserve rate and the discount rate from two percentage points accounting, total reserves in a given statement week to one point, which would again reduce the interest -the bulk of which are required reserves-are essen- cost advantage of borrowing at the window relative tially predetermined by the level of deposits two to buying funds in the Federal funds market. Conse- weeks earlier. quently, desired borrowing at the window would Because of lagged reserve accounting, the Fed still decline initially below the $2 billion level, and banks affects the money supply primarily through the Fed- would attempt to meet their reserve needs by pur- eral funds rate under the current procedure.1 None- chasing funds in the Federal funds market. With the theless, the post-October 6 procedure differs signifi- supply of nonborrowed reserves fixed at the target cantly from the old one. Under the new procedure level, however, the increased demand for Federal the Fed does not set specific short-run objectives for funds would put upward pressure on the funds rate. the funds rate. Instead, it sets a short-run target for It seems reasonable to expect that the funds rate nonborrowed reserves believed to be consistent with would have to rise to roughly 13 percent, which money supply objectives. Since the level of total re- would re-establish the two-point spread that “had serves that the banking system must hold in a given brought forth $2 billion of borrowing before the dis- statement week is essentially predetermined under count rate was changed. lagged reserve accounting,2 the selection of a target 3 The discussion in this section assumes there is a non- 1 For a more complete description of the mechanism of negligible level of borrowing, which normally implies monetary control under the new procedure, see Robert D. that the funds rate will exceed the discount rate. Sections Laurent, “Lagged Reserve Accounting and the Fed’s 3 and 4 of this paper discuss how the present procedure New Operating Procedure,” Economic Perspectives, works where the funds rate is below the discount rate.
Federal Reserve Bank of Chicago (Midyear 1982), pp. 4 32-43. Under this procedure, if the money supply departs from its path, and the nonborrowed reserve target is not 2 This statement assumes that the banking system’s changed; the implied level of borrowing, the spread, and demand for excess reserves is small, which has generally the funds rate would all change in a way that would tend been the case in recent years. to bring money back to path over time.
FEDERAL RESERVE BANK OF RICHMOND 13 To summarize, under the pre -October 6 procedure cent. In these circumstances, few if any banks would the Fed fixed the funds rate within narrow limits, borrow at the window for adjustment purposes since and a change in the discount rate led to (1) a sus- the cost of doing so would exceed the cost of pur- tained change in the spread between the funds rate chasing funds in the Federal funds market. A re- and the discount rate and (2) a change in the duction in the discount rate to, say, 9½ percent allocation of total reserves between borrowed re- would leave the discount rate above the funds rate serves and nonborrowed reserves. Under the post- and would not have a significant effect on either the October 6 procedure, the Fed sets targets for non- demand for borrowed reserves or the level of pur- borrowed reserves, and, a change in the discount rate chases in the Federal funds market. Hence, any causes the funds rate to change by about the same effect on the funds rate would be small, and the amount in the short run. Since the funds rate is the spread between the discount rate and the funds rate central channel through which the Fed affects the would narrow. More generally, when borrowing money supply under both procedures, it is obvious is negligible and the funds rate drops below the that the role of discount rate changes in the overall discount rate under the current procedure, the role monetary control process differs significantly between of the discount rate is similar to its role under the the two procedures. Under the pre-October 6 pro- old procedure.5 cedure, a discount rate change did not affect the funds rate. Therefore, discount rate changes were of sec- 4. Tiering in the Federal Funds Market ondary importance in the monetary control process, There is, unfortunately, an additional complication although they may have had so-called “announce- that has to be mentioned in discussing the relation- ment” effects in the financial markets. Under the ship between the discount rate and the Federal funds post-October 6 procedure, a change in the discount rate under the post-October 6 procedure. This com- rate produces an approximately one-for-one change 6 plication was of practical importance in August 1982 in the funds rate in the absence of a significant change when borrowing at the discount window was in the in the level of borrowing implied by the nonborrowed $300-$500 million range, even though the funds rate reserve target. Therefore, discount rate changes was below the discount rate. The relevant questions play a more important role in the monetary control are: (1) why was there so much borrowing at the process in the present set-up. Further, these differ- window when it appeared to be cheaper to buy funds ences imply that the rationale for discount rate in the Federal funds market than to borrow them at changes will differ between the two procedures. For the window, and (2) what did this situation imply for example, if the funds rate was substantially above the impact of discount rate changes on the funds rate ? the discount rate in the pre-October 6 regime, one A plausible answer to the first question is that might recommend an increase in the discount rate to some degree of “tiering” existed in the Federal funds bring it into better alignment with the funds rate and market at that time: that is, some banks could pur- other market rates. This rationale, however, would chase funds only at a premium above the going rate. be much less applicable under the new procedure. There is evidence, in fact, that some banks may have been paying premiums as high as 100 basis points 3. The Post-October 6 Procedure with in this period. In these circumstances, banks forced Negligible Borrowing to pay a premium might have found it advantageous to borrow at the window even though the funds The above description of the effect of discount rate rate quoted in the market was below the discount changes on the Federal funds rate under the post- rate. As an example, suppose the funds rate is October 6 operating procedure is only valid in the 9½ percent and the discount rate is 10 percent but more normal case where borrowed reserves are that there are several banks that can borrow only at a above a negligible level. On several occasions in the post-October 6 period, however, borrowing has 5 For empirical evidence on the differential effect on the dropped to negligible levels, and the funds rate has funds rate of (1) discount rate increases when the funds fallen below the discount rate. In this situation, rate is above the discount rate versus (2) discount rate decreases when the funds rate is below the discount rate, discount rate changes should not affect the funds rate. see Gordon H. Sellon, Jr. and Diane Seibert, “The Dis- (This statement and some of the following state- count Rate: Experience Under Reserve Targeting,” Economic Review, Federal Reserve Bank of Kansas City ments are subject to qualification as explained in the (September/October 1982). next section.) Suppose, for example, that the dis- 6 The period referred to here includes the statement count rate is 10 percent and the funds rate is 9 per- weeks ending July 28 through August 25.
14 ECONOMIC REVIEW, JANUARY/FEBRUARY 1983 premium ranging from 0 to 100 basis points. In this 5. Summary of the Role of the Discount situation banks that have to pay premiums exceeding Rate in the Post-October 6 Regime 50 basis points will find the discount window more To summarize, when the Fed sets nonborrowed attractive than the funds market. In such a case reserve targets, as it does under the post-October 6 borrowing of, say, $300 million might be consistent procedure, changes in the discount rate will probably with a negative spread between the quoted funds cause roughly equal changes in the Federal funds rate and the discount rate. rate when the funds rate is above the discount rate. In the presence of tiering and with borrowing If borrowing drops to a negligible level, however, above a negligible level, a reduction in the discount and the funds rate falls below the discount rate, dis- rate should cause the funds rate to decline even count rate changes will probably not affect the funds if it were already below the discount rate. The rate significantly. When the quoted funds rate is mechanism is the same as that outlined in the dis- below the discount rate but there is a nonnegligible cussion in section 2 above. Returning to the ex- level of borrowing, such borrowing probably reflects ample in the preceding paragraph, a reduction in the tiering in the Federal funds market. In this situ- discount rate to 9½ percent would initially increase ation the impact of a change in the discount rate on the demand for borrowed reserves at the window the funds rate should be similar to the case when the because all banks paying any premium in the Federal funds rate is above the discount rate. funds market would then find it less costly to borrow While it is possible to delineate these three cases temporarily at the window. With the nonborrowed from an analytical standpoint, it is not always easy reserve target and therefore the supply of nonbor- to do so in practice. In particular, it may be difficult rowed reserves unchanged, however, the funds rate at times to specify the point at which borrowing has would come under downward pressure.7 reached a “negligible” level where all borrowing is of an interest-insensitive nature. For this reason it 7 A second possible explanation for nonnegligible bor- may be difficult to predict the effect of a discount rowing levels when the funds rate is below the discount is that the borrowing is not interest-sensitive adjustment rate change on the funds rate when borrowing is at a borrowing, but borrowing of a longer term nature that is low level and the funds rate is below the discount insensitive to the spread between the funds rate and the discount rate. Such borrowing might include, for ex- rate. ample, borrowing by banks that have been denied access to the Federal funds market because they are perceived to be high credit risks. In principle, the target for non- effect on the funds rate. This case is essentially equiva- borrowed reserves should include the full amount of lent to the situation discussed in the third section of this interest-insensitive borrowing in each statement week. article where adjustment borrowing is negligible. If the In practice, such borrowing, when it arises, is not always borrowing in a given week were a mixture of interest- included immediately in the target. If all of the borrowed insensitive borrowing and interest-sensitive borrowing reserves in a particular statement week were interest- due to tiering, discount rate changes would affect the insensitive, a change in the discount rate would have no funds rate as discussed in the present section.
FEDERAL RESERVE BANK OF RICHMOND 15