Skip to main content

Discount rate vs fed funds rate

The fed funds rate and the discount rate are two distinct interest rates the Federal Reserve uses in monetary policy. The fed funds rate is the rate banks charge each other overnight to lend reserves. The discount rate is the rate the Fed charges banks directly when they borrow from the Fed's "discount window." Both affect the supply of money and credit in the economy, but they work through different channels. Understanding the difference is essential for reading Fed announcements and grasping how the Fed manages the financial system during normal times and crises. This article explains both rates, how they interact, and why the Fed maintains two separate tools.

Quick definition: The fed funds rate is what banks charge each other overnight; the discount rate is what the Federal Reserve charges banks when they borrow directly from the Fed. The discount rate is typically set above the fed funds rate to discourage overuse.

Key takeaways​

  • The fed funds rate is an overnight rate between banks; the discount rate is the Fed's direct lending rate to banks
  • The discount rate is typically set at least 0.5 percentage points above the fed funds rate to discourage banks from relying on Fed loans
  • The discount rate acts as a ceiling on the fed funds rate—banks won't pay more to each other than they'd pay the Fed
  • The Fed has three main lending facilities: primary credit (most common), secondary credit (riskier), and seasonal credit (for agricultural banks)
  • During financial crises, the Fed lowers the discount rate to encourage banks to borrow and restore market confidence

What is the discount window?​

The discount window is the Fed's lending facility where banks can borrow directly from the Federal Reserve. The discount window has a long history—it dates back to the 1913 Federal Reserve Act and was inspired by Walter Bagehot's principle that central banks should lend freely during crises.

The idea is simple: if a bank needs reserves and can't find another bank willing to lend at an acceptable rate, it can knock on the Fed's "window" and borrow. The Fed acts as a lender of last resort—the institution of final recourse when normal credit markets seize up.

This is different from open-market operations (OMOs), where the Fed buys and sells securities to influence the money supply broadly. OMOs affect the overall fed funds rate indirectly. The discount window is direct: a bank walks in, the Fed assesses the bank's soundness, and the Fed lends if it agrees.

The three types of discount window credit​

The Fed offers three tiers of lending through the discount window:

1. Primary credit​

The most common type. Sound banks (those with good capital ratios and supervision ratings) can borrow at the primary credit rate, which is the discount rate that newspapers report. This is the default option. The interest rate is relatively low, and the Fed doesn't question the collateral too strictly; it trusts the bank's creditworthiness.

Example: JPMorgan Chase, a well-capitalized bank, needs $100 million in reserves overnight. It can call the Fed's discount window, and the Fed will lend at the primary credit rate—say, 5.50%—without hesitation.

2. Secondary credit​

For weaker banks or banks with supervisory concerns, the Fed offers secondary credit at a higher rate, typically 0.5 percentage points above the primary credit rate. Secondary credit carries more scrutiny: the Fed reviews the bank's books before lending and may impose restrictions on how the funds are used.

Example: A regional bank with capital concerns can borrow through secondary credit at 6.00% (0.50% above primary), but the Fed may require the bank to submit a capital-raising plan as a condition.

3. Seasonal credit​

Seasonal credit is available to smaller banks with predictable, recurring seasonal funding needs (agricultural banks needing extra funds during harvest season). The rate is an average of the fed funds rate and the primary credit rate.

Example: A bank in Iowa that funds seasonal grain loans borrows through seasonal credit at a rate between the fed funds and primary credit rates.

The discount rate and the fed funds rate: how they relate​

The discount rate is typically set above the fed funds rate. As of 2024, if the fed funds target is 5.25%–5.50%, the primary credit rate might be 5.75%. This gap is called the penalty spread.

The penalty spread is intentional. The Fed wants banks to borrow from each other first (in the fed funds market) and use the discount window only as a last resort. Here's why:

  1. Stigma avoidance: In normal times, borrowing from the Fed signals weakness. If a bank's peers see it heading to the discount window, they might worry about the bank's health and be less willing to lend to it. The penalty spread discourages routine borrowing.

  2. Market discipline: By forcing banks to borrow from each other, the Fed lets the private market price credit risk. A risky bank pays more for reserves in the overnight market; a sound bank pays less. This incentivizes prudent behavior.

  3. Economic efficiency: Reserve lending among banks is usually more efficient than central-bank lending because banks know each other's actual conditions better than the Fed does (though the Fed is an expert regulator).

How the discount rate acts as a ceiling​

Because the discount rate is higher than the fed funds rate, the fed funds rate can never sustainably exceed the discount rate. If the fed funds rate (cost of borrowing from another bank) is 5.50% and the primary credit rate (cost of borrowing from the Fed) is 5.75%, no bank will borrow from another bank at more than 5.75%. They'll just borrow from the Fed instead.

This ceiling effect is mathematically precise:

Diagram:

Discount rate (primary credit) = 5.75%
↑
Fed funds rate cannot exceed this (= 5.50% target)
↑
Minimum rate = 0% or even negative (the Fed can pay IORB, lowering the floor)

Similarly, the Fed can set a floor on the fed funds rate by paying interest on reserve balances (IORB). If the Fed pays 0.25% interest on reserves, banks are reluctant to lend reserves to each other for less than 0.25%, because they could earn 0.25% risk-free by holding reserves at the Fed.

So the fed funds rate is bounded:

Floor = Interest on Reserve Balances (0.25%)
Fed funds rate target = 2.50%
Ceiling = Primary credit discount rate (2.75%)

The Fed doesn't physically enforce these bounds; they're automatic consequences of rational bank behavior.

Changes to the discount rate during policy cycles​

The Fed typically moves the discount rate in lockstep with its fed funds rate target. When the Fed raises the fed funds target, it also raises the primary credit rate. When it cuts the fed funds target, it cuts the discount rate too.

However, the discount rate sometimes moves independently when the Fed wants to send a special signal.

Crisis response: Lowering the discount rate​

During a financial crisis, the Fed often lowers the discount rate and widens credit availability to encourage banks to borrow and prevent a liquidity freeze.

2008 financial crisis: In September 2008, as Lehman Brothers collapsed, banks were terrified to lend to each other. The fed funds market nearly froze. The Fed lowered the primary credit rate from 5.75% (relative to fed funds target of 2%) to 2.25% (relative to fed funds target of 0.125%), a dramatic cut. The Fed also created new lending facilities (TSLF, PDCF) with even lower rates. The message: we have money to lend; use it. Banks slowly resumed lending to each other.

2020 pandemic: In March 2020, as COVID-19 crashed financial markets, the Fed cut the fed funds rate to near zero and lowered the primary credit rate from 2.75% to 0.25%. The Fed also doubled the amount banks could borrow (from 120% to 300% of capital). Banks flooded into the discount window, borrowing more than $100 billion some nights. This time, the crisis abated quickly because the Fed's action was swift and the pandemic was understood to be temporary.

Normal times: Maintaining the penalty spread​

In normal times, the Fed maintains a penalty spread of 0.5–1.0 percentage points above the fed funds target. This keeps the discount window a last-resort facility, not a substitutes for overnight markets.

If the penalty spread shrinks, banks flood the discount window, which dilutes the effectiveness of Fed policy. If the spread is too large, banks might not borrow even during genuine crises, defeating the purpose of the lender-of-last-resort function.

Real-world example: The 2022–2023 rate tightening cycle​

In March 2022, the Fed began raising the fed funds rate target to fight inflation.

  • March 2022: Fed funds target raised to 0.25%–0.50%; primary credit rate raised to 0.75%.
  • June 2022: Fed funds target raised to 1.50%–1.75%; primary credit rate raised to 2.00%.
  • December 2022: Fed funds target raised to 4.25%–4.50%; primary credit rate raised to 4.75%.
  • July 2023: Fed funds target reached 5.25%–5.50%; primary credit rate reached 5.75%.

Throughout this cycle, the primary credit rate stayed roughly 0.5 percentage points above the fed funds target. Discount-window borrowing remained minimal—in normal times, banks preferred the fed funds market.

But in March 2023, as Silicon Valley Bank and Signature Bank failed, banks grew nervous about each other and the fed funds market tightened (fed funds rate spiked toward the upper end of the target range). Banks rushed to the discount window, borrowing $150+ billion. The Fed also created a new lending facility (Bank Term Funding Program) offering loans at rates closer to the primary credit rate. Within days, panic subsided and discount borrowing fell sharply.

The cycle showed the discount window in action: it was irrelevant in normal times but essential during stress.

Why the Fed uses both rates​

The Fed could, in theory, rely only on the fed funds rate and open-market operations. But the dual-rate system (fed funds + discount rate) offers advantages:

  1. Flexibility during crises: The Fed can lower the discount rate faster than it can move the fed funds target, signaling emergency lending availability immediately.

  2. Distinction between normal and emergency lending: The penalty spread signals that discount window borrowing is unusual. Removing the spread during a crisis sends a "don't be embarrassed" message.

  3. Direct control over the deposit-taking tier: Large banks, which borrow in the fed funds market, are influenced by the fed funds rate. Smaller banks and credit unions are more influenced by the discount rate. By maintaining two rates, the Fed can influence different tiers of the financial system.

  4. Historical continuity: The discount window predates the fed funds market as a monetary-policy tool. Central banks worldwide use similar two-tier systems.

The spread between the two rates​

The spread (discount rate minus fed funds target) is an indicator of Fed confidence and market stress.

  • 0.5–1.0% spread in normal times: Banks prefer the fed funds market; discount window is quiet.
  • Spread shrinks below 0.25% during mild stress: Banks find fed funds borrowing slightly more attractive but also consider the discount window as a backup.
  • Spread widens or discount rate is lowered during crises: The Fed is signaling "use the window." Discount borrowing surges.
  • Negative spread (emergency lending): The Fed inverts the normal hierarchy, making discount lending cheaper than fed funds. This is rare and a sign of extreme stress.

During the 2008 crisis, the Fed allowed the spread to widen dramatically (discount rate fell to 0.5% while fed funds target was 0%, inverting the spread) and created special facilities with rates as low as 0.25%. This emergency signaling was crucial.

Common mistakes about discount rate vs fed funds rate​

Mistake 1: Confusing the discount rate with the discount rate on commercial paper. The Fed's discount rate is for bank reserves only. In 2008, the Fed also created a "Commercial Paper Funding Facility" (CPFF) offering lower rates on corporate debt. These are different programs.

Mistake 2: Thinking the discount rate is set by the market. The Fed sets the discount rate; it's not a market rate. The Fed announces it; banks take it or leave it.

Mistake 3: Assuming the discount rate is used routinely. Outside of crises, discount-window borrowing is minimal. The window is a last-resort facility; routine borrowing happens in the fed funds market.

Mistake 4: Overlooking the distinction between primary and secondary credit. The Fed has tiered rates. A weak bank pays 0.5% more than a strong bank. This is intentional: it's a form of market discipline.

Mistake 5: Forgetting that the discount rate sends a policy signal. Changes to the discount rate can signal different things. A cut during normal times might signal the Fed is concerned about credit conditions. A cut during a crisis signals the Fed is throwing open the lending window. Context matters.

FAQ​

How much can banks borrow through the discount window?​

In normal times, banks can borrow up to an amount based on their capital. During crises, the Fed typically increases the limit. In 2008, the limit was raised. In 2020, the limit was raised to 300% of capital. The Fed can raise it further if needed.

What collateral do banks need to offer to borrow at the discount window?​

Banks must offer collateral (usually Treasury bonds or high-quality mortgage-backed securities). The Fed assesses the collateral's value and lends a percentage of that value (say, 80% for Treasuries, less for riskier securities). The Fed is risk-averse in this regard, so good collateral is essential.

Can non-banks borrow at the discount window?​

No. The discount window is for depository institutions (banks, credit unions, thrifts). Non-bank lenders (shadow banks, hedge funds) cannot access it. This is partly why shadow banks are more vulnerable during crises—they don't have a lender-of-last-resort backstop like banks do.

Why doesn't the Fed just eliminate the penalty spread and let the discount rate equal the fed funds rate?​

Because then banks would borrow from the Fed routinely instead of from each other, making the discount window a substitute for the fed funds market, not a backstop. The penalty spread incentivizes banks to manage their reserves efficiently and borrow from each other first. Eliminating the spread would muddy the distinction between routine and emergency lending.

What happens if the fed funds rate rises above the discount rate?​

It shouldn't in normal circumstances, because banks would just borrow from the Fed instead. But in extreme stress (like 2008), if the fed funds rate spikes and is about to exceed the discount rate, the Fed will lower the discount rate to restore order. The Fed won't allow arbitrage where borrowing from each other is more expensive than borrowing from the Fed.

Summary​

The federal funds rate and the discount rate are two separate but related tools the Fed uses to manage the financial system. The fed funds rate is the overnight rate banks charge each other; the discount rate is what the Fed charges banks directly. The discount rate is set above the fed funds rate (typically 0.5–1.0 percentage points) to maintain the discount window as a lender-of-last-resort facility, not a routine source of funds. During crises, the Fed lowers the discount rate to encourage borrowing and restore confidence. The gap between the two rates signals the Fed's assessment of financial-system stress: a widening gap or falling discount rate indicates emergency lending. Understanding both rates is essential for tracking Fed policy and predicting how credit conditions will evolve.

Next​

→ Open market operations