Making Sense of the Fed Discount Rate

[fed discount rate]While investors contemplate the recent increase in the Fed Discount Rate, astute investors realize this arbitrary figure means nothing in regards to fighting inflation or decreasing the money supply. Although the Federal Reserve Discount Rate may have made an impact in 2008, its impact on the market was lost after the Fed expanded the balance sheet to buy illiquid assets in late 2008 through 2009.

The Federal Funds Rate

The Federal Funds rate is the rate that is usually thrown around investing discourse when the Fed seeks a new target. The Federal Funds rate is the rate set by the Fed through its open market policies, and it is the price at which reserves are lent overnight from one member bank to another. When banks have excess reserves to lend, or if they need to borrow additional reserves from other banks, they do so at this price.

The actual rate, of course, depends on supply and demand; however, the Fed conducts open market operations with primary dealers to influence the rate within their target. The Fed can temporarily add or subtract reserves to or from the market, but these mechanics are only applied in the short term.

The Fed Discount Rate

The Fed Discount Rate is on par with the Federal Funds rate, but earns very little discussion in the press and even in investing circles. This rate is set by the Fed and is the price at which the Federal Reserve branches lend reserves to other institutions. Typically, banks that use this mechanism to achieve greater reserves are in dire need of cash for the medium term.

Why These Rates Don't Matter

When the Federal Reserve acts to raise rates, most investors perceive this as an inflation-fighting mechanism, when in today's market, it has little to no effect. The simple truth is that the rates the Federal Reserve sets for its member banks are only important when banks are short on reserves and thus have to borrow from other banks.

However, as we all know, the quantitative easing programs enacted by the Federal Reserve bought Agency debt, as well as Treasuries, for a price that may have well been above market price, and the program settled the transactions with reserves at the Fed. The result is that the full $1.2 trillion quantitative easing program was deposited directly into the reserve accounts of these banks. Thus, there isn't a single bank operating in the United States that does not have enough reserves, as Federal Law mandates that banks need only $1 in reserve for $10 in loans.

How the Fed Can Use Monetary Policy

Knowing now that the target rates set by the Fed are nothing but a scheme for good press, you're now wondering what the Fed would have to do to curb the amount of money in circulation. The Federal Reserve, to decrease the available money supply, must now act to sell off its assets in exchange for reserves from member banks – which are then kept off the market and in the hands of the Federal Reserve. Without selling the assets it purchased from 2008 to 2009, there is no way the Federal Reserve can decrease the money supply, especially not to the same degree at which it increased it in just two years.

The Fed Discount Rate may not mean much on the road to inflation ahead. Here's a simple way to convert some assets to an inflation hedge.

The Fed Discount Rate may not mean much on the road to inflation ahead. Here's a simple way to convert some assets to an inflation hedge.

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