Home > Business & the Economy > Controlling Economic Growth with the Federal Reserve Discount Rate

Controlling Economic Growth with the Federal Reserve Discount Rate

The Federal Reserve (the Fed) is charged with managing the U.S. money supply and keeping inflation in check.  Increasing the money supply (i.e., printing money) is intended to spur economic growth.  Additional money is supposed to make it less expensive to borrow, thereby encouraging investment and growth. It also devalues the dollar against other currencies, which should increase exports by making American goods less expensive to buy internationally.

The Conference Board includes the Federal Reserve money supply as part of its composite index of leading economic indicators.  Bankers, economists, currency traders and exporters are particularly tuned into the supply of money in the financial system.    

The discount rate is another primary tool the Fed utilizes to achieve its objectives.  The discount rate is the interest rate the Fed charges other banks to borrow from it. 

If banks are in the business of lending money, why are they borrowing from the Fed?  It’s called leverage.  Being able to borrow money from the Fed allows banks to leverage their deposits and loans.  Banks only keep a fraction of the money deposited to them on hand.  The rest is loaned out.  However, if you want your money, they have to be able to pay you when you to withdraw it.  The ability to borrow from the Fed allows banks the ability to keep fewer reserves and lend more money. Consequently, the discount rate affects the interest rate banks charge you to borrow money.

In general, the Fed increases the discount rate when the economy is doing well.  Raising the interest rate slows growth, which is intended to keep inflation in check.  Furthermore, in good economic times, people don’t need as much of an incentive to take risks or borrow money and are willing to pay a higher interest rate to access capital.  Conversely, in recessionary times, the Fed will reduce the discount rate to lower lending rates and spur economic growth. 

If you study the history of the Fed discount rate, you’ll see increases during periods of economic prosperity and rate cuts during recessions.  The size and timing of the rate cuts or increases are indications of the economic conditions. 

This is evidenced in the Fed discount rate over the past two years. The Fed dropped the rate seven times in 2008, reducing the rate by 0.75% three times.  The rate was 0.5% at the end of 2008, and hasn’t been that low in over 30 years.  This is an indication of the severity of the current recession, as if you needed another sign.

The Fed raised the rate 0.25% in February 2010, on signs the economy was strengthening.  However, the Fed has indicated that it doesn’t expect any rate increases for an extended period of time.  With rumblings that the recovery is slowing, the Fed may be pushed to lower the rate once again, but it doesn’t have much further it can go.

You don’t have to wear yourself out trying to understand monetary policy, money supply and inflation factors.  If you want to get a quick synopsis of the Fed’s current view on the economy, just watch their action on the discount rate.  No change means you can expect things to stay the same for a while.  A reduction is a sign of trouble, and an increase is an indication that things are getting better.

With the Fed saying that they expect to hold the discount rate static for an extended period of time, you can expect the economy to continue to slog along.  It may not be great, but hopefully it doesn’t get worse.

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