An abstract for this article is not available.Federal Reserve System ; Federal funds rate

Alfred Broaddus

Timothy Q. Cook

English

Research Papers in Economics

THE RELATIONSHIP BETWEEN
AND THE FEDERAL FUNDS
THE DISCOUNT RATE
RATE UNDER THE
FEDERAL RESERVE’S POST-OCTOBER 6, 1979
OPERATING PROCEDURE*
Alfred Broaddus and Timothy Cook
Federal Reserve bank directors, who are respon-
sible for establishing the discount rate at their re-
spective banks, subject to the approval of the Board
of Governors, naturally have a strong interest in the
likely effect of discount rate changes on the Federal
funds rate. Under the post-October 6, 1979, Federal
Reserve operating procedure, changes in the discount
rate have typically been followed by changes in the
Federal funds rate in the same direction and of
roughly the same magnitude, under usual condi-
tions where the funds rate is above the discount rate.
For example, an increase in the discount rate of one
percentage point has typically been followed by
about a one percentage point increase in the funds
rate. This relationship between the two rates differs
from their relationship in the period before October 6,
1979, when changes in the discount rate did not
generally have a significant impact on the funds rate.
The purpose of this article is to explain the basic
difference between the procedures used in the two
periods and to show how this difference has affected
the relationship between the funds rate and the dis-
count rate. More broadly, the article attempts to
clarify the role of the discount rate in the overall
conduct of monetary policy in the post-October 6
operating regime.
1. The Pre-October 6 Procedure
Before October 6, 1979, the Federal Reserve
sought to achieve its money supply objectives by
manipulating the Federal funds rate directly through
open market operations. Under this procedure the
Fed first chose a desired funds rate level believed
to be consistent with the money supply objective.
If the actual funds rate deviated from this level,
* This paper was prepared as part of a staff presentation
to the Board of Directors of the Federal Reserve Bank
of Richmond on September 9, 1982.
the Fed bought or sold U. S. securities in the
open market to move the funds rate back to the
desired level. In doing so it necessarily increased or
decreased the outstanding level of nonborrowed re-
serves-that is, the level of reserves held by banks
other than those borrowed at the discount window-
but the magnitude of these changes received little
attention.
The key point to keep in mind about the pre-
October 6 procedure is that under this procedure
the Fed fixed the funds rate within very narrow
limits in the short run. In this situation, sustained
changes in the spread between the funds rate and the
discount rate were possible following a change in the
discount rate. To see this, assume that the funds
rate was above the discount rate. When the Fed
changed the discount rate, the change affected the
spread between the funds rate and the discount rate,
and the change in the spread, in turn, affected the
proportion of its total reserve need the banking sys-
tem borrowed at the discount window. (A reduction
in the discount rate increased borrowing and vice-
versa.) If nothing else had happened, this change in
borrowing would have affected activity in the Federal
funds market and therefore would have affected the
funds rate. Under the old procedure, however, the
Fed varied the supply of nonborrowed reserves to
whatever extent was necessary to keep the funds rate
at the desired level. In brief, under the old pro-
cedure, changes in the discount rate affected ( 1) the
spread between the funds rate and the discount rate
and (2) the allocation of total reserves between bor-
rowed reserves and nonborrowed reserves. They did
not significantly affect the funds rate.
The following example may help to clarify these
points. Suppose that under the old procedure the
Fed was fixing the funds rate at 12 percent and
the discount rate was 10 percent. Suppose further
that at this two percentage point spread, commer-
12 ECONOMIC REVIEW, JANUARY/FEBRUARY 1983cial banks in the aggregate were borrowing $2 billion
at the discount window. If the Fed then raised
the discount rate to 11 percent, thereby reducing
the spread from two percentage points to one point,
the interest cost advantage of borrowing temporarily
at the discount window instead of buying funds in
the funds market would diminish. As a result, banks
would reduce their borrowing at the window and
increase their purchases of funds in the. Federal funds
market. The increased purchases of Federal funds,
in turn, would put upward pressure on the funds
rate. In order to keep the funds rate at its desired
level, the Fed would supply additional nonborrowed
reserves through open market operations. The final
result would be a reduction in the spread between
the funds rate and the discount rate and a reduction
in the proportion of the banking system’s total re-
serve need supplied through the window, but no
significant change in the funds rate.
2. The Post-October 6 Procedure
It is important to understand what the October 6
change did and did not involve. The change was
not a move to a procedure in which the Fed controls
the money supply by manipulating the supply of total
reserves. The Fed cannot manipulate the supply of
total reserves in the current statement week under
present arrangements due to the present system of
lagged reserve accounting. With lagged reserve
accounting, total reserves in a given statement week
-the bulk of which are required reserves-are essen-
tially predetermined by the level of deposits two
weeks earlier.
Because of lagged reserve accounting, the Fed still
affects the money supply primarily through the Fed-
eral funds rate under the current procedure.
1 None-
theless, the post-October 6 procedure differs signifi-
cantly from the old one. Under the new procedure
the Fed does not set specific short-run objectives for
the funds rate. Instead, it sets a short-run target for
nonborrowed reserves believed to be consistent with
money supply objectives. Since the level of total re-
serves that the banking system must hold in a given
statement week is essentially predetermined under
lagged reserve accounting,
2 the selection of a target
1 For a more complete description of the mechanism of
monetary control under the new procedure, see Robert D.
Laurent, “Lagged Reserve Accounting and the Fed’s
New Operating Procedure,” Economic Perspectives,
Federal Reserve Bank of Chicago (Midyear 1982), pp.
32-43.
2 This statement assumes that the banking system’s
demand for excess reserves is small, which has generally
been the case in recent years.
for nonborrowed reserves for a given statement week
implies a particular level of borrowed reserves in that
week. Because, as noted above, the demand for bor-
rowed reserves depends on the spread between the
funds rate and the discount rate, the implied level of
borrowing in a particular statement week will be con-
sistent with a particular, spread. Therefore, under
the new procedure the choice of a nonborrowed re-
serve target strongly influences the spread between
the funds rate and the discount rate in the current
statement week.
3,
4 It follows that if the discount
rate is changed, the funds rate must change by a
roughly equal amount to re-establish the spread
between the funds rate and the discount rate that is
consistent with the borrowing level implied by the
nonborrowed reserve target. If the implied level of
borrowing changes significantly in subsequent weeks,
both the spread and the funds rate will change. Alter-
natively, if the implied level of borrowing remains
roughly the same, both the spread and the new level
of the funds rate will be maintained.
Consider again the above example of a 12 percent
funds rate and a 10 percent discount rate. Assume
further that the level of borrowing implied by the
nonborrowed reserves target is $2 billion. Suppose
again that the Fed raises the discount rate to 11
percent. Initially, the increase in the discount rate
would again reduce the spread between the funds
rate and the discount rate from two percentage points
to one point, which would again reduce the interest
cost advantage of borrowing at the window relative
to buying funds in the Federal funds market. Conse-
quently, desired borrowing at the window would
decline initially below the $2 billion level, and banks
would attempt to meet their reserve needs by pur-
chasing funds in the Federal funds market. With the
supply of nonborrowed reserves fixed at the target
level, however, the increased demand for Federal
funds would put upward pressure on the funds rate.
It seems reasonable to expect that the funds rate
would have to rise to roughly 13 percent, which
would re-establish the two-point spread that “had
brought forth $2 billion of borrowing before the dis-
count rate was changed.
3 The discussion in this section assumes there is a non-
negligible level of borrowing, which normally implies
that the funds rate will exceed the discount rate. Sections
3 and 4 of this paper discuss how the present procedure
works where the funds rate is below the discount rate.
4 Under this procedure, if the money supply departs from
its path, and the nonborrowed reserve target is not
changed; the implied level of borrowing, the spread, and
the funds rate would all change in a way that would tend
to bring money back to path over time.
FEDERAL RESERVE BANK OF RICHMOND 13To summarize, under the  pre -October 6 procedure
the Fed fixed the funds rate within narrow limits,
and a change in the discount rate led to (1) a sus-
tained change in the spread between the funds rate
and the discount rate and (2) a change in the
allocation of total reserves between borrowed re-
serves and nonborrowed reserves. Under the  post-
October 6 procedure, the Fed sets targets for non-
borrowed reserves, and, a change in the discount rate
causes the funds rate to change by about the same
amount in the short run. Since the funds rate is the
central channel through which the Fed affects the
money supply under both procedures, it is obvious
that the role of discount rate changes in the overall
monetary control process differs significantly between
the two procedures. Under the pre-October 6 pro-
cedure, a discount rate change did not affect the funds
rate. Therefore, discount rate changes were of sec-
ondary importance in the monetary control process,
although they may have had so-called “announce-
ment” effects in the financial markets. Under the
post-October 6 procedure, a change in the discount
rate produces an approximately one-for-one change
in the funds rate in the absence of a significant change
in the level of borrowing implied by the nonborrowed
reserve target. Therefore, discount rate changes
play a more important role in the monetary control
process in the present set-up. Further, these differ-
ences imply that the rationale for discount rate
changes will differ between the two procedures. For
example, if the funds rate was substantially above
the discount rate in the pre-October 6 regime, one
might recommend an increase in the discount rate to
bring it into better alignment with the funds rate and
other market rates. This rationale, however, would
be much less applicable under the new procedure.
3. The Post-October 6 Procedure with
Negligible Borrowing
The above description of the effect of discount rate
changes on the Federal funds rate under the post-
October 6 operating procedure is only valid in the
more normal case where borrowed reserves are
above a negligible level. On several occasions in the
post-October 6 period, however, borrowing has
dropped to negligible levels, and the funds rate has
fallen below the discount rate. In this situation,
discount rate changes should not affect the funds rate.
(This statement and some of the following state-
ments are subject to qualification as explained in the
next section.) Suppose, for example, that the dis-
count rate is 10 percent and the funds rate is 9 per-
cent. In these circumstances, few if any banks would
borrow at the window for adjustment purposes since
the cost of doing so would exceed the cost of pur-
chasing funds in the Federal funds market. A re-
duction in the discount rate to, say, 9½ percent
would leave the discount rate above the funds rate
and would not have a significant effect on either the
demand for borrowed reserves or the level of pur-
chases in the Federal funds market. Hence, any
effect on the funds rate would be small, and the
spread between the discount rate and the funds rate
would narrow. More generally, when borrowing
is negligible and the funds rate drops below the
discount rate under the current procedure, the role
of the discount rate is similar to its role under the
old procedure.
5
4. Tiering in the Federal Funds Market
There is, unfortunately, an additional complication
that has to be mentioned in discussing the relation-
ship between the discount rate and the Federal funds
rate under the post-October 6 procedure. This com-
plication was of practical importance in August 1982
6
when borrowing at the discount window was in the
$300-$500 million range, even though the funds rate
was below the discount rate. The relevant questions
are: (1) why was there so much borrowing at the
window when it appeared to be cheaper to buy funds
in the Federal funds market than to borrow them at
the window, and (2) what did this situation imply for
the impact of discount rate changes on the funds rate ?
A plausible answer to the first question is that
some degree of “tiering” existed in the Federal funds
market at that time: that is, some banks could pur-
chase funds only at a premium above the going rate.
There is evidence, in fact, that some banks may have
been paying premiums as high as 100 basis points
in this period. In these circumstances, banks forced
to pay a premium might have found it advantageous
to borrow at the window even though the funds
rate quoted in the market was below the discount
rate. As an example, suppose the funds rate is
9½ percent and the discount rate is 10 percent but
that there are several banks that can borrow only at a
5 For empirical evidence on the differential effect on the
funds rate of (1) discount rate increases when the funds
rate is above the discount rate versus (2) discount rate
decreases when the funds rate is below the discount rate,
see Gordon H. Sellon, Jr. and Diane Seibert, “The Dis-
count Rate: Experience Under Reserve Targeting,”
Economic Review,  Federal Reserve Bank of Kansas City
(September/October 1982).
6 The period referred to here includes the statement
weeks ending July 28 through August 25.
14 ECONOMIC REVIEW, JANUARY/FEBRUARY 1983premium ranging from 0 to 100 basis points. In this
situation banks that have to pay premiums exceeding
50 basis points will find the discount window more
attractive than the funds market. In such a case
borrowing of, say, $300 million might be consistent
with a negative spread between the quoted funds
rate and the discount rate.
In the presence of tiering and with borrowing
above a negligible level, a reduction in the discount
rate should cause the funds rate to decline even
if it were already below the discount rate. The
mechanism is the same as that outlined in the dis-
cussion in section 2 above. Returning to the ex-
ample in the preceding paragraph, a reduction in the
discount rate to 9½ percent would initially increase
the demand for borrowed reserves at the window
because all banks paying any premium in the Federal
funds market would then find it less costly to borrow
temporarily at the window. With the nonborrowed
reserve target and therefore the supply of nonbor-
rowed reserves unchanged, however, the funds rate
would come under downward pressure.
7
7 A second possible explanation for nonnegligible bor-
rowing levels when the funds rate is below the discount
is that the borrowing is not interest-sensitive adjustment
borrowing, but borrowing of a longer term nature that is
insensitive to the spread between the funds rate and the
discount rate. Such borrowing might include, for ex-
ample, borrowing by banks that have been denied access
to the Federal funds market because they are perceived
to be high credit risks. In principle, the target for non-
borrowed reserves should include the full amount of
interest-insensitive borrowing in each statement week.
In practice, such borrowing, when it arises, is not always
included immediately in the target. If all of the borrowed
reserves in a particular statement week were interest-
insensitive, a change in the discount rate would have no
5. Summary of the Role of the Discount
Rate in the Post-October 6 Regime
To summarize, when the Fed sets nonborrowed
reserve targets, as it does under the post-October 6
procedure, changes in the discount rate will probably
cause roughly equal changes in the Federal funds
rate when the funds rate is above the discount rate.
If borrowing drops to a negligible level, however,
and the funds rate falls below the discount rate, dis-
count rate changes will probably not affect the funds
rate significantly. When the quoted funds rate is
below the discount rate but there is a nonnegligible
level of borrowing, such borrowing probably reflects
tiering in the Federal funds market. In this situ-
ation the impact of a change in the discount rate on
the funds rate should be similar to the case when the
funds rate is above the discount rate.
While it is possible to delineate these three cases
from an analytical standpoint, it is not always easy
to do so in practice. In particular, it may be difficult
at times to specify the point at which borrowing has
reached a “negligible” level where all borrowing is
of an interest-insensitive nature. For this reason it
may be difficult to predict the effect of a discount
rate change on the funds rate when borrowing is at a
low level and the funds rate is below the discount
rate.
effect on the funds rate. This case is essentially equiva-
lent to the situation discussed in the third section of this
article where adjustment borrowing is negligible. If the
borrowing in a given week were a mixture of interest-
insensitive borrowing and interest-sensitive borrowing
due to tiering, discount rate changes would affect the
funds rate as discussed in the present section.
FEDERAL RESERVE BANK OF RICHMOND 15

The relationship between the discount rate and the federal funds rate under the Federal Reserve's post-October 6th 1979 operating procedure

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The relationship between the discount rate and the federal funds rate under the Federal Reserve's post-October 6th 1979 operating procedure

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