There was a run on the banks. The stock market crashed more than 50% over a three-week period. Credit markets seizing up. If it sounds like the financial crisis of 2007 you would be off by a century. Those events occurred during the Panic of 1907. This was the first major financial crisis of our country and it set in motion the moves that created the Federal Reserve mechanism. The idea was to give banks, particularly troubled banks, a way to lend to each other by making the Federal government a lender of last resort.
Two of the powers given to the Federal Reserve in 1907 that remain today are the establishment and maintenance of the Federal funds rate as well as the discount rate. The Federal funds rate is the one most investors and consumers are aware of, but the discount rate is a key metric that, although not market driven plays a primary role in the monetary policy of our country.
The discount rate is also used to help businesses appropriately price the future value of revenue in present-day terms. This article will review what the discount rate is, how it differs from the Federal funds rate, and how it impacts the economy. We’ll wrap up the article by reviewing the other definition of the discount rate and its role in discounted cash flow analysis.
What is the discount rate?
The discount rate has two meanings in the financial/investment community. The most common definition is when referring to the interest rate the Federal Reserve Banks charge to financial institutions who borrow money from their overnight discount window. The other definition is a measurement used by practitioners of fundamental analysis to determine the current value of cash flows when performing a discounted cash flow analysis. We'll take a look at each of these definitions separately.
The discount rate is an interest rate
Interest rates, in general, are determined by market forces. However, the discount rate is not a market-driven rate. It is determined by the board of directors from the 12 banks that make up the Federal Reserve Banks. Banks are required to keep a “reserve requirement” that ensures they have adequate funds to cover deposits. At the close of business, some banks have a surplus of their reserve requirement that they lend to other banks. However, some banks fall below the reserve requirement threshold. These banks have two options to cover the shortfall: borrow from other banks or borrow from the Federal Reserve via their lending facility known as the deposit window. This is where the discount rate comes into play.
The discount rate applies specifically to the short-term loans, which are generally just overnight loans, that the Federal Reserve provides to banks that help them cover their reserve requirement. This rate is generally set slightly higher than the benchmark Federal funds rate. This is because the discount rate is supposed to be a measure of last resort. If a bank needs to borrow from the deposit window it is generally seen as a sign that a bank would not be able to get a loan from another bank, and therefore need to pay the Fed’s higher rate.
Another thing to know about the discount rate is that it is not just one rate; it is actually three separate rates that are progressively higher. The primary credit rate is the discount rate. When the discount rate was first instituted in 1907, this rate was set at 1 percentage point higher than the federal funds rate which is one of the primary drivers of interest rates. This rate is available to banks with good credit. Beyond the primary rate, there is a secondary rate that is provided to banks that don’t qualify for the primary rate. This rate is set 50 basis points above the primary rate. The final rate is the seasonal credit rate. This is a market-driven rate that is offered to institutions that experience predictable fluctuations in deposits because they rely on markets such as agriculture or tourism. This rate is not benchmarked to the discount rate but is considered part of the Federal Reserve's discount window. The seasonal rate is reset every 14 days and is calculated as the average of the three-month CD rate and the daily effective federal funds rate during that period of time.
How is the discount rate different from the Federal Funds rate?
The Federal Funds rate is the interest rate that financial institutions charge when lending to each other. This is also the interest rate that is used to calculate the interest rate that consumers pay for everything from credit cards to mortgages. When financial institutions such as banks borrow from each other it is just transferring existing reserves among banks without increasing the monetary supply. The discount rate, by contrast, is the interest rate that the Federal Reserve charges to banks that make collateralized, usually overnight loans, from their discount window. When these institutions borrow from the discount window, it increases the monetary supply by creating new reserves.
Loans taken from the discount window are also collateralized loans meaning banks have to be able to show that they have liquid funds necessary to cover the money they are receiving.
Prior to the financial crisis of 2007, the Federal Reserve’s policy was to make the discount rate a “penalty rate”. This meant that the interest rate would be slightly higher than the Federal Funds rate to discourage banks from using the discount window. This was set at 1 percentage point. As a response to the financial crisis, the Federal Reserve lowered the discount rate to match the Federal Funds rate to encourage financial institutions to borrow money from the Fed which would increase reserves, providing much-needed liquidity in the money supply. At the same time, the Federal Reserve removed the overnight restriction and allowed banks to hold these loans for up to 90 days.
After the crisis subsided, the Federal Reserve began to widen the spread back to tighten the money supply. As of October 2018, the spread between the Federal Funds rate and the discount rate was 0.75% (2.00% vs. 2.75%).
Does the discount rate affect the economy?
Although the discount rate is not set by the market, it does have an effect on a variety of interest rates such as:
- The bank-to-bank interest rates known as Libor. These loans are short-term (at intervals of one month up to one year). The Libor rate is also used to calculate credit card rates and the rates on adjustable-rate mortgages.
- The prime rate. This is the interest rate that banks charge to their best customers. A change in the prime rate affects all other interest rates.
- The interest rates on fixed rate mortgages and money market interest rates.
The larger effect that the discount rate plays in our economy is its role in setting monetary policy. During the financial crisis of 2007, the Federal Reserve specifically chose to lower the discount rate to encourage banks to borrow through the discount window. The result was an increase in cash reserves as the Federal Reserve had to inject liquidity into the financial system. That is counter to the normal goal of the discount rate which is to act as a penalty of sorts and encouraging banks to lend to one another. This simply moves existing cash reserves without expanding monetary policy. As the financial markets healed from the crisis, the Federal Reserve began increasing the spread between the Federal funds rate and the discount rate and now only provides for overnight lending as was its original policy.
How the discount rate is used in discounted cash flow analysis
Another completely unrelated use of the term “discount rate” in financial terms is when a business attempts to use discounted cash flow analysis to determine the present value of future cash flow.
For investors, discounted cash flow analysis is an attempt to determine how valuable a company is today based on how future projected revenues. Many businesses have predictable revenue streams that they can project into the future. The problem for investors and analysts is that projecting a dollar of future revenue, not to mention hundreds of thousands of dollars in new revenue, are just projections. It is almost impossible to predict what market conditions will be like, particularly when these forecasts are 5 to 10 years in the future.
So to account for that cash flow, it first has to be discounted using some sort of rate. How companies may come up with the exact discount rate is beyond the scope of this article but it takes into account the timeframe being used, future expectations for revenue growth and future free cash flow estimates.
For example, if a business projects $1,000 in revenue for next year from a new customer, they have to forecast a present value of that money. If the discount rate they apply is 10%, that $1,000 would be valued at $909.09 using the formula =1000/ (1+0.1). If a business was projecting that $1,000 in revenue to occur in two years, it would be valued at $826.45 using the same formula.
The final word on discount rate
In 2007, the role of the Federal Reserve was being questioned as they essentially took over our financial system and opened a spigot that provided liquidity to many banks that were under duress. However, when the Federal Reserve was created in 1907, it was seen as a necessity to put in place safeguards that protected our financial system.
One of the tools given to the Federal Reserve as an instrument of policy was the discount rate. This was an interest rate set by the Federal Reserve banks as a way of providing the most distressed banks with a way of borrowing money that would, in turn, help them meet their reserve requirement.
The discount rate is not set by the market but by the Federal Reserve Banks. This rate historically has been one point above the Federal funds rate. However, during the financial crisis of 2007, the rate was lowered to 0.5% to help inject liquidity into the financial markets. As of October 2018, the spread between the discount rate and the Federal funds rate is pushing back towards 1% at 0.75%.
Although it is not dictated by the market, the discount rate does have an impact on several key interest rates that can affect investors and consumers. On a macroeconomic level, the discount rate can be an indication of the current direction of our nation’s monetary policy. During times of financial volatility, the discount rate is one tool that the Federal Reserve can use to expand monetary supply.
The discount rate is also a term used in determining a company’s discounted cash flow analysis. This is one of many metrics used by practitioners of fundamental analysis as a way of determining an accurate future value for a company based on its projected revenue and free cash flow.