The Federal Reserve (the “Fed”) (est. 1913) raises its discount rate one quarter of a percent. That’s headline news! Why? What does it mean? Who does it affect? Let’s back up, slow down, and take a look at the Fed and briefly summarize what it is and how it works.

The Fed is a central banking system comprised of 12 regional Federal Reserve Banks. These banks are located in Atlanta, Boston, Chicago, Cleveland, Dallas, Kansas City, Minneapolis, New York, Philadelphia, Richmond, Saint Louis, and San Francisco. The role of each bank is to provide central bank services, such as check collection, access to the Federal Reserve Wire Network, and credit advances at the Federal Discount Window. In addition, Federal Reserve Banks establish monetary policy along with the Federal Reserve Board of Governors (seven members) who issue regulations and monitor commercial and savings banks to ensure that financial depository institutions follow Federal Reserve regulations. The Federal Reserve uses three policy tools to carry out its monetary objectives: (1) the discount rate, (2) open market activities, and (3) reserve requirements.

Discount rate

The discount rate is the rate charged by the Federal Reserve Banks for loans at the Federal Reserve Discount Window. When the “Fed” increases its cost of lending to depository financial institutions, that cost is carried through and reflected in higher interest rates to the borrowers of those financial institutions.

Open market activity

Open market activity refers to the Federal Reserve Bank Open Market desk which buys and sells U.S. government securities, agency securities, and bankers’ acceptances from member banks. When the Fed buys through its Open Market desk, it deposits a check at the selling bank, thus increasing that institution’s money and reserves. When more money becomes available, the tendency is toward looser credit and lower interest rates. When the “Fed” sells through its Open Market desk, money markets operate in reverse: Credit tends to tighten and interest rates increase.

Reserve requirements

All member banks are required to maintain a portion of their deposits as legal reserves. Reserve requirements serve two basic functions in banking. They are a source of protection for depositors’ money, and they provide one of the monetary tools the Federal Reserve uses to adjust credit. By raising or lowering the amount of required reserves, the Federal Reserve creates or reduces funds available at financial depository institutions; thus it can stimulate or tighten available bank credit and the ability of banks and saving institutions to issue credit.

Each of these monetary tools is carefully watched by analysts and management of concerned companies. The cost of business activity is immediately affected by a change in the interest rate. Companies and investors are concerned with the direction of interest rates. Is the change an extension of a present trend, the end of a passing trend, the reversal of a trend, a pause in a ongoing trend, etc.? Each interest rate change is analyzed as a predictor of future interest rates.

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