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July IS, 1989 eCONOMIC COMMeNTaRY Federal Reserve Bank of Cleveland Setting the Discount Rate by E.J. Stevens An uncommonly wide spread existed in the first half of this year between the federal funds rate, the rate that banks pay to borrow from one another, and the discount rate, the rate that banks pay to borrow from a Federal Reserve Bank. The federal funds rate rose more than 300 basis points (three percentage points) over the 12 months ending in March 1989. The discount rate, on the other hand, was raised by a total of only 100 basis points over that same period: 50 basis points in August 1988 and another 50 basis points in February of this year. As a result, the spread between the federal funds rate and the discount rate sometimes exceeded 275 basis points, although it has declined recently. A rate spread wider than even 200 basis points is unusual (see table I). In the past, such extreme values typically episodes. These have alternated with contrasting periods of relatively close comovement of the funds rate and the discount rate. It is tempting to look for a uniform explanation of this historical pattern: perhaps policymakers typically underestimate peak interest rates and then get "locked in" to a discount-rate level for fear that even a small increase will be misinterpreted as a major tightening of policy; perhaps a higher rate would disadvantage small banks; perhaps restrictive policy requires a wide spread. The trouble with such explanations is that none of them seems sufficiently universal to account for all of the episodes of unusually wide spreads in the past 25 years. However, such speculation does raise a more fundamental question: for monetary policy purposes, does it make any difference what the level of the discount rate is? emerged only in periods when the discount rate had reached a kind of plateau (see figure I). Prior to 1983, these When the Federal Reserve Banks opened for business 75 years ago, raising and lowering the discount rate was discount-rate plateaus all occurred near business-cycle peaks. Since 1983, conceived of as the principal monetary policy tool for tightening and loosening the supply of reserves. But, in the 1920s, open market operations took over this plateaus and their associated wide rate spreads emerged during the periods of restrictive monetary policy that have interrupted the long-run disintlationary downward trend of nominal interest rates in the U.S. economy. policy function, now managed by the Federal Open Market Committee (FOMC). I Open market purchases and sales of This year's wide rate spread thus was only the latest in a series of such ISSN 0428-1276 U.S. government securities add and drain reserves directly, effectively - An independently determined discount rate seems irrelevant as long as open market operations implement monetary policy. This suggests moving the discount rate frequently in alignment with market rates. Instead, however, the Federal Reserve could use the discount rate as an independent tool to enrich the policy process. In so doing, the central bank could improve the reliability of short-term policy information available to the public and prevent market activity based on faulty assumptions about policy intentions. The level of the federal funds rate and determining the level of the federal to act simultaneously. If the Board of All of these arguments raise important funds rate. The level of the discount rate relative to the funds rate simply influences the proportion of total reserves that are created through discount- Governors thinks that a change is called for when none of the 12 Banks has recommended a change, it may make informal efforts to elicit a recommendation. issues, but none gets to our fundamental question. Regardless of who sets the discount rate and whether it should be above or below market rates, and as- TABLE 1 suming that it is not to be fixed at a permanent level for all time, is there a rationale for using the rate as a policy tool independent of open market opera- Size of Spread (basis points) tions? If there is not, then the best basis for setting the rate would seem to be to keep it aligned with market rates that reflect monetary policy. But if there is such a rationale, then on what basis should rate-setting decisions be made? window borrowing. Open market operations could always compensate for fluctuations in borrowing, thereby maintaining effective long-run control of total bank reserves and the monetary base. The discount rate has been lower than the federal funds rate during most of the past 25 years without ever generating much borrowing.' Reluctance of Monetary policy can be thought of as a decision to provide a particular amount of reserves to the banking system; banks to borrow from the discount window, despite a favorable rate spread, has two primary explanations. One is that Reserve Banks limit the circum- policy actions are reflected in the federal funds rate and other money market interest rates as demand interacts with supply. An independently determined discount rate seems irrelevant: in the long run, if the monetary base and market interest rates get where they have to go, policy has been implemented. stances under which a bank may use the borrowing privilege, reinforced by careful scrutiny of the frequency and amount that any bank actually borrows. • The Discount Rate as a Source of Policy Information The other is that banks fear damage to their market reputations if it were to become known that they were placing substantial reliance on this nonmarket Changes in the discount rate can improve the reliability of policy information available to markets. This "announcement effect" will improve the source of funds. Federal Reserve's chances of getting the funds rate where it has to go, of getting the monetary base where it has to be, and of getting the whole spec- Hence the question: is there a rationale for using the discount rate as an independent monetary policy tool, rather than simply moving the discount rate to A frequent suggestion over the years has been that, as a matter of policy, the discount rate should always lie above keep it aligned with the key FOMCdetermined federal funds rate at which banks borrow from one another? This Economic Commentary explains one the federal funds rate and other money market rates, so that borrowing would entail a penalty. A related idea is to eliminate most administrative oversight, trum of interest rates, monetary aggregates, credit flows, income, and output where they have to go in order to implement policy and achieve its implicit or explicit inflation-rate objective. rationale: accepting all other current monetary policy arrangements as given, changes in the discount rate could be used to convey useful information counting on the penalty aspect to keep borrowing to a minimum level consistent with those infrequent occasions when a bank is unable to access market The reason the discount rate can enrich the policy process is that markets operate in an uncertain environment. 4 about monetary policy to the public. sources of funds. • Current Mechanics and Subsidiary Issues Another suggestion that would eliminate administrative overhead is to set the discount rate itself automatically, The mechanics of setting the discount rate are not complicated. The Board of Directors of each of the 12 Federal Reserve Banks is required to recommend a rate setting for its Bank to the Board of Govemors of the Federal Reserve System no less frequently than every two weeks. 2 If the Board of whether above or below market rates, by some formula linking it to market rates. Counterarguments emphasize the potential organizational costs of such a change. In particular, the directors of Reserve Banks, who receive only nomi- Govemors approves the recommenda- nal remuneration for their service to the nation. are thought to be attracted to tion, typically it will notify any of the other 12 Banks that have not made the same recommendation so that their Boards of Directors have an opportunity their positions chiefly by their role in maintaining prudent national monetary policy.' A related thought is that involving the Reserve Banks in the rare-setting process also lends weight to the positions of their presidents within the FOMe. Policy actions depend on what policymakers foresee, and market actions depend on what market participants foresee and think that the Fed foresees. The better informed markets are about Fed intentions, the more effortlessly markets will reach equilibrium. Frequency (no. of mos.) looks of FOMC members, FOMC targets for growth of monetary aggregates, and discussion of broader Percent of cases Cumulative percent 13 4% 4% >250,<300 22 8% 11% >200,<250 II 4% 15% >150,<200 21 7% 22% >100,<150 27 9% 31% >50,<100 66 22% 54% >0,<50 70 24% 78% 64 22% 100% 294 100% >300 <0 a. Monthly average rates, January 1965 to June 1989. SOURCE: Board of Governors of the Federal Reserve System. Fedwatchers, provides a contemporaneous signal of current policy. This signal is not clear, however, because interpretation of the items is always uncertain and never unanimous. Moreover, the signal reflects only today's policy setting; it says little about future policy actions. In this situation, an occasional increase or decrease in the discount rate could certify that policymakers viewed recent levels or changes in the federal funds rate not as incidental or temporary, but as the necessary consequence of ongoing monetary policy. One reason for changing the rate would be a perception in the Federal Reserve that markets were misinterpreting policy intentions. The other would be a recognition in the Federal Reserve that its own outlook had changed, from less to more certain- monetary policy objectives. While policy actions. This was because devia- fresh when delivered, this information is 26 weeks old before it is updated by another Humphrey-Hawkins report. tions of incoming data (and of market projections of future data) from target paths implied by the policy record would suggest the impending need for The policy record of each FOMC meet- tighter or easier policy. ing is released after the next succeeding meeting. It provides only historical information about policy intentions because it is about six weeks old when delivered, and 12 weeks old when updated. Further This is no longer the case. Deposit-rate deregulation and reversal of the postwar upward trend of interest rates in the qualitative information might be sought in the occasional speeches and other statements of FOMC members, but these necessarily represent individual views, not statements of FOMC policy. Sources of information about policy intentions are readily enumerated. Twice a year, the FOMC's HumphreyHawkins report to Congress includes information about the economic out- the nature of open market operations can be observed on a daily basis. Careful scrutiny of these items, either directly or through the judgment of professional FEDERAL FUNDS RATE MINUS DISCOUNT RATEFREQUENCY DISTRIBUTION OF THE RATE SPREADa WeekJy and monthly data for the targeted monetary aggregates become available with only a two-week delay. For considerable periods in the past, these data provided important information about prospective open market 1980s introduced substantial uncertainty into relationships between the monetary aggregates and national output and prices. Deviations of monetary aggregates from target paths within the annual ranges no longer playa central role in determining FOMC actions, at least on a dependable short-run basis. The annual target ranges themselves are quite broad, so that an equally broad spectrum of monetary aggregate levels may be consistent with the targets. ty about the joint implications of its objective and its economic outlook for the direction or extent of future changes in the funds rate. Within these guidelines, the discount rate might be changed with varying frequency, and result in variable spreads from the funds rate. The information content of a discountrate change need not be restricted to the direction and size of the change: discount-rate changes typically are announced in a press release that includes a brief explanation of the action. For example, "In the light of inflationary pressures in the economy, the Federal Reserve Board announced ... an increase in the discount rate ... (2/24/89)." Such brief statements can provide the public with some sense of direction about policy, whereas open market operations are conducted without any accompanying explanation for adding or draining reserves. The level of the federal funds rate and determining the level of the federal to act simultaneously. If the Board of All of these arguments raise important funds rate. The level of the discount rate relative to the funds rate simply influences the proportion of total reserves that are created through discount- Governors thinks that a change is called for when none of the 12 Banks has recommended a change, it may make informal efforts to elicit a recommendation. issues, but none gets to our fundamental question. Regardless of who sets the discount rate and whether it should be above or below market rates, and as- TABLE 1 suming that it is not to be fixed at a permanent level for all time, is there a rationale for using the rate as a policy tool independent of open market opera- Size of Spread (basis points) tions? If there is not, then the best basis for setting the rate would seem to be to keep it aligned with market rates that reflect monetary policy. But if there is such a rationale, then on what basis should rate-setting decisions be made? window borrowing. Open market operations could always compensate for fluctuations in borrowing, thereby maintaining effective long-run control of total bank reserves and the monetary base. The discount rate has been lower than the federal funds rate during most of the past 25 years without ever generating much borrowing.' Reluctance of Monetary policy can be thought of as a decision to provide a particular amount of reserves to the banking system; banks to borrow from the discount window, despite a favorable rate spread, has two primary explanations. One is that Reserve Banks limit the circum- policy actions are reflected in the federal funds rate and other money market interest rates as demand interacts with supply. An independently determined discount rate seems irrelevant: in the long run, if the monetary base and market interest rates get where they have to go, policy has been implemented. stances under which a bank may use the borrowing privilege, reinforced by careful scrutiny of the frequency and amount that any bank actually borrows. • The Discount Rate as a Source of Policy Information The other is that banks fear damage to their market reputations if it were to become known that they were placing substantial reliance on this nonmarket Changes in the discount rate can improve the reliability of policy information available to markets. This "announcement effect" will improve the source of funds. Federal Reserve's chances of getting the funds rate where it has to go, of getting the monetary base where it has to be, and of getting the whole spec- Hence the question: is there a rationale for using the discount rate as an independent monetary policy tool, rather than simply moving the discount rate to A frequent suggestion over the years has been that, as a matter of policy, the discount rate should always lie above keep it aligned with the key FOMCdetermined federal funds rate at which banks borrow from one another? This Economic Commentary explains one the federal funds rate and other money market rates, so that borrowing would entail a penalty. A related idea is to eliminate most administrative oversight, trum of interest rates, monetary aggregates, credit flows, income, and output where they have to go in order to implement policy and achieve its implicit or explicit inflation-rate objective. rationale: accepting all other current monetary policy arrangements as given, changes in the discount rate could be used to convey useful information counting on the penalty aspect to keep borrowing to a minimum level consistent with those infrequent occasions when a bank is unable to access market The reason the discount rate can enrich the policy process is that markets operate in an uncertain environment. 4 about monetary policy to the public. sources of funds. • Current Mechanics and Subsidiary Issues Another suggestion that would eliminate administrative overhead is to set the discount rate itself automatically, The mechanics of setting the discount rate are not complicated. The Board of Directors of each of the 12 Federal Reserve Banks is required to recommend a rate setting for its Bank to the Board of Govemors of the Federal Reserve System no less frequently than every two weeks. 2 If the Board of whether above or below market rates, by some formula linking it to market rates. Counterarguments emphasize the potential organizational costs of such a change. In particular, the directors of Reserve Banks, who receive only nomi- Govemors approves the recommenda- nal remuneration for their service to the nation. are thought to be attracted to tion, typically it will notify any of the other 12 Banks that have not made the same recommendation so that their Boards of Directors have an opportunity their positions chiefly by their role in maintaining prudent national monetary policy.' A related thought is that involving the Reserve Banks in the rare-setting process also lends weight to the positions of their presidents within the FOMe. Policy actions depend on what policymakers foresee, and market actions depend on what market participants foresee and think that the Fed foresees. The better informed markets are about Fed intentions, the more effortlessly markets will reach equilibrium. Frequency (no. of mos.) looks of FOMC members, FOMC targets for growth of monetary aggregates, and discussion of broader Percent of cases Cumulative percent 13 4% 4% >250,<300 22 8% 11% >200,<250 II 4% 15% >150,<200 21 7% 22% >100,<150 27 9% 31% >50,<100 66 22% 54% >0,<50 70 24% 78% 64 22% 100% 294 100% >300 <0 a. Monthly average rates, January 1965 to June 1989. SOURCE: Board of Governors of the Federal Reserve System. Fedwatchers, provides a contemporaneous signal of current policy. This signal is not clear, however, because interpretation of the items is always uncertain and never unanimous. Moreover, the signal reflects only today's policy setting; it says little about future policy actions. In this situation, an occasional increase or decrease in the discount rate could certify that policymakers viewed recent levels or changes in the federal funds rate not as incidental or temporary, but as the necessary consequence of ongoing monetary policy. One reason for changing the rate would be a perception in the Federal Reserve that markets were misinterpreting policy intentions. The other would be a recognition in the Federal Reserve that its own outlook had changed, from less to more certain- monetary policy objectives. While policy actions. This was because devia- fresh when delivered, this information is 26 weeks old before it is updated by another Humphrey-Hawkins report. tions of incoming data (and of market projections of future data) from target paths implied by the policy record would suggest the impending need for The policy record of each FOMC meet- tighter or easier policy. ing is released after the next succeeding meeting. It provides only historical information about policy intentions because it is about six weeks old when delivered, and 12 weeks old when updated. Further This is no longer the case. Deposit-rate deregulation and reversal of the postwar upward trend of interest rates in the qualitative information might be sought in the occasional speeches and other statements of FOMC members, but these necessarily represent individual views, not statements of FOMC policy. Sources of information about policy intentions are readily enumerated. Twice a year, the FOMC's HumphreyHawkins report to Congress includes information about the economic out- the nature of open market operations can be observed on a daily basis. Careful scrutiny of these items, either directly or through the judgment of professional FEDERAL FUNDS RATE MINUS DISCOUNT RATEFREQUENCY DISTRIBUTION OF THE RATE SPREADa WeekJy and monthly data for the targeted monetary aggregates become available with only a two-week delay. For considerable periods in the past, these data provided important information about prospective open market 1980s introduced substantial uncertainty into relationships between the monetary aggregates and national output and prices. Deviations of monetary aggregates from target paths within the annual ranges no longer playa central role in determining FOMC actions, at least on a dependable short-run basis. The annual target ranges themselves are quite broad, so that an equally broad spectrum of monetary aggregate levels may be consistent with the targets. ty about the joint implications of its objective and its economic outlook for the direction or extent of future changes in the funds rate. Within these guidelines, the discount rate might be changed with varying frequency, and result in variable spreads from the funds rate. The information content of a discountrate change need not be restricted to the direction and size of the change: discount-rate changes typically are announced in a press release that includes a brief explanation of the action. For example, "In the light of inflationary pressures in the economy, the Federal Reserve Board announced ... an increase in the discount rate ... (2/24/89)." Such brief statements can provide the public with some sense of direction about policy, whereas open market operations are conducted without any accompanying explanation for adding or draining reserves. FIGURE 1 THE FEDERAL FUNDS RATE AND THE DISCOUNT RATE 15 Federal funds rate 10 5 OL-J--L~ 1965 __ L-~-L~~L-~~-L~ __ ~~-L~ __ L-J--L~ __ L-~~~~ 1970 1975 1980 1985 1990 1970 1975 1980 1985 1990 Percent 15 5 NOTE: The level of the discount rate between March 17. 1980. and November 17. 1981. includes a surcharge in addition to the basic rate. This surcharge varied between levied on borrowing by banks with deposits in excess of $500 million. It was intended to discourage frequent use of the discount window and to encourage o and 4 percent. large banks to adjust their loans and investments SOURCE: quickly in response to market conditions. Board of Governors of the Federal Reserve System. of routine attempts to keep it aligned with the federal funds rate (see figure I). Nonetheless, alignment has been far from perfect. Contrary to popular In any case, the discount-rate-setting mechanism provides a means of convey- or tighter future monetary policy than might otherwise be reflected in current ing useful policy information. The directors of a District Bank could recommend a change in the rate to inform the Board of Governors of the direction they financial-market prices. Resetting the rate may thereby impose immediate losses, but prevent future days or weeks of market activity based on incorrect or believe monetary policy should take to achieve FOMC objectives. An actual change in the discount rate, approved by the Board of Governors, could be used less-certain policy assumptions. • Past Changes in the Rate With hindsight, many past changes in rate and of closely associated market rates. In fact, it was adjusted in only a quarter of the months plotted in the figure. Markets may have received useful to assure fuller incorporation of an easier the discount rate have the appearance policy information from the Federal belief, the discount rate is not necessarily the bellwether of the federal funds • Reserve in those months in which the • Conclusion discount rate was changed, but not in the others.6 Delayed release of the FOMC policy record is an important basis for the potential usefulness of the discount rate as an independent tool of monetary policy. Reasons for, contingencies at- The usefulness of information conveyed by a change in the discount rate need not be uniform over time. In particular, the operating procedure employed by the FOMC to guide open market operations might influence the effect of tached to, and FOMC policy ket operations could provide discount-rate changes. When the funds rate is the direct target of daily open market operations, there should be little market uncertainty about the "equilib- icy outlook that now might be attributed to changes in the discount rate. But delayed release makes the policy record useful largely as an historical document. rium" funds rate. This is because the Federal Reserve can enter the market to add or drain reserves on a daily basis whenever the funds rate varies from the FOMC's desired equilibrium. any dissents from the record guiding open maruntil the next meeting much of the flavor of pol- Immediate release of the policy record could make changes in the discount rate less informative, except to the extent that fundamental changes in policy thinking between meetings might war- Uncertainty should be greater when open market operations seek to provide only a predetermined amount of non- rant an immediate signal to markets. Frequent changes to maintain alignment with the funds rate would seem to borrowed reserves. In this case, the market must discover an equilibrium funds rate consistent with the FOMC open market policy setting because the be the appropriate way to manage the discount rate if immediate release of the policy record provided more information about the basis for policy actions than currently is the case. FOMC explicitly will tolerate some variance in the funds rate. Changes in the discount rate may provide information that helps the market find the right funds rate in this latter case, while no such information is needed in the former case, when the funds rate is the direct policy target. Setting the discount rate inescapably involves this choice between inertia and alignment. Directors' recommendations to change the discount rate could be a tool for conveying useful information from the public to policymakers. Actual discretionary changes in the discount rate could be a tool for conveying useful information to the public about the near-term intentions of monetary policy. Footnotes 5. some- times are thought to reflect regional rather rent form of the FOMC to control open than national conditions, but this seems un- market operations. The Committee consists likely as a general rule. Directors know that of the seven members of the Board of Governors of the Federal Reserve System, the presi- there is no basis for maintaining regional dif- dent of the Federal Reserve Bank of New of integrated global money and capital York, and, on an annual rotating basis, four markets. Also, the expertise of many direc- of the presidents of the other II Federal Reserve Banks. (The Cleveland Bank presi- tors is not about the regional economy, but dent serves every other year, alternating with dustries in which they are employed. the president of the Chicago Bank.) The 6. Substantial effort has gone into the FOMC now meets eight times each year, with additional meetings as necessary (typi- search for evidence that past discount-rate changes conveyed new information and cally by telephone conference). therefore had an impact on securities prices, ferences in interest rates in the modern world about national and global conditions in the in- Under this scenario for managing the rate, an unusually wide spread of the 2. This rate recommendation funds rate above a relatively stable discount rate would have an explanation. It would suggest a persistent tendency for policymakers to be, or to want to be seen adjustment credit and seasonal credit. useful summary of the evolution of these efforts can be found in Timothy Cook and 3. Adjustment borrowing has averaged Thomas Hahn, "The Information Content of to be, both more surprised than the market at the need for tighter policy, as well as dubious that so restrictive a policy would continue to be needed. 4. An extension of this idea is that the dis- is for the level of the basic discount rate borrowers pay for 1.9% of total reserves over the past 25 years, with a standard deviation of 1.6%. count window for adjustment credit could be - E.1. Stevens is an assistant vice president and economist at the Federal Reserve Bank of Cleveland. The author thanks .fohn Carlson. William Gavin. Owen Humpage, and Mark Sniderman for useful discussion. Susan Black provided able research assistance. The views stated herein are those of the author and not necessarily those of the Federal Reserve Bank of Cleveland or of the Board of Governors of the Federal Reserve System. with at least partial success. Citations and a Discount Rate Announcements and Their Ef- fect on Market Interest Rates," Journal of Money. Credit. and Banking, vol. 20, no. 2 (May 1988), pp. 167-180. closed completely. Banks in exigent circumstances that prevent access to market sources of liquidity would run overnight overdrafts, making up the reserve deficiency on succeeding days. Presumably they would also have to pay the penalty for such overdrafts. currently the larger of $50, or the larger of 10% or a rate 2 percentage points above the federal funds rate, in addition 10 making up the deficiency. Inertia in the discount rate is the source of its power, but this poses a danger. By allowing a wide or narrow spread between market rates and an unchanged discount rate to build up over a longer and longer interval, a change in the rate, when it comes, might suggest a major In either case, changes in the discount rate may provide information about the short-run future, affecting rates on securities with maturities longer than innovation in policy thinking. Apprehension of market overreaction could then make a rate-change decision increasingly difficult for the Board of overnight federal funds. Failure to detect information effects uniformly in past discount-rate changes would not disprove the information rationale for Govemors, even though the language of a rate-change announcement can be used to shape its interpretation. On the other hand, changing the rate frequently Cleveland, managing the discount rate. An adverse finding says only that the rate was not managed this way during some time periods in the past or, if it was, that the and in minor amounts to avoid this danger would trivialize the tool into a routine device for rate alignment. Address Correction Requested: result was too small to be detected. Directors' rate recommendations 1. The Banking Act of 1935 created the cur- Federal Reserve Bank of Cleveland Research Department P.O. Box 6387 OH 44101 Please send corrected mailing label to the above address. Material may be reprinted provided that the source is credited. Please send copies of reprinted materials to the editor. BULK RATE U.S. Postage Paid Cleveland, OH Permit No. 385 • Reserve in those months in which the • Conclusion discount rate was changed, but not in the others.6 Delayed release of the FOMC policy record is an important basis for the potential usefulness of the discount rate as an independent tool of monetary policy. Reasons for, contingencies at- The usefulness of information conveyed by a change in the discount rate need not be uniform over time. In particular, the operating procedure employed by the FOMC to guide open market operations might influence the effect of tached to, and FOMC policy ket operations could provide discount-rate changes. When the funds rate is the direct target of daily open market operations, there should be little market uncertainty about the "equilib- icy outlook that now might be attributed to changes in the discount rate. But delayed release makes the policy record useful largely as an historical document. rium" funds rate. This is because the Federal Reserve can enter the market to add or drain reserves on a daily basis whenever the funds rate varies from the FOMC's desired equilibrium. any dissents from the record guiding open maruntil the next meeting much of the flavor of pol- Immediate release of the policy record could make changes in the discount rate less informative, except to the extent that fundamental changes in policy thinking between meetings might war- Uncertainty should be greater when open market operations seek to provide only a predetermined amount of non- rant an immediate signal to markets. Frequent changes to maintain alignment with the funds rate would seem to borrowed reserves. In this case, the market must discover an equilibrium funds rate consistent with the FOMC open market policy setting because the be the appropriate way to manage the discount rate if immediate release of the policy record provided more information about the basis for policy actions than currently is the case. FOMC explicitly will tolerate some variance in the funds rate. Changes in the discount rate may provide information that helps the market find the right funds rate in this latter case, while no such information is needed in the former case, when the funds rate is the direct policy target. Setting the discount rate inescapably involves this choice between inertia and alignment. Directors' recommendations to change the discount rate could be a tool for conveying useful information from the public to policymakers. Actual discretionary changes in the discount rate could be a tool for conveying useful information to the public about the near-term intentions of monetary policy. Footnotes 5. some- times are thought to reflect regional rather rent form of the FOMC to control open than national conditions, but this seems un- market operations. The Committee consists likely as a general rule. Directors know that of the seven members of the Board of Governors of the Federal Reserve System, the presi- there is no basis for maintaining regional dif- dent of the Federal Reserve Bank of New of integrated global money and capital York, and, on an annual rotating basis, four markets. Also, the expertise of many direc- of the presidents of the other II Federal Reserve Banks. (The Cleveland Bank presi- tors is not about the regional economy, but dent serves every other year, alternating with dustries in which they are employed. the president of the Chicago Bank.) The 6. Substantial effort has gone into the FOMC now meets eight times each year, with additional meetings as necessary (typi- search for evidence that past discount-rate changes conveyed new information and cally by telephone conference). therefore had an impact on securities prices, ferences in interest rates in the modern world about national and global conditions in the in- Under this scenario for managing the rate, an unusually wide spread of the 2. This rate recommendation funds rate above a relatively stable discount rate would have an explanation. It would suggest a persistent tendency for policymakers to be, or to want to be seen adjustment credit and seasonal credit. useful summary of the evolution of these efforts can be found in Timothy Cook and 3. Adjustment borrowing has averaged Thomas Hahn, "The Information Content of to be, both more surprised than the market at the need for tighter policy, as well as dubious that so restrictive a policy would continue to be needed. 4. An extension of this idea is that the dis- is for the level of the basic discount rate borrowers pay for 1.9% of total reserves over the past 25 years, with a standard deviation of 1.6%. count window for adjustment credit could be - E.1. Stevens is an assistant vice president and economist at the Federal Reserve Bank of Cleveland. The author thanks .fohn Carlson. William Gavin. Owen Humpage, and Mark Sniderman for useful discussion. Susan Black provided able research assistance. The views stated herein are those of the author and not necessarily those of the Federal Reserve Bank of Cleveland or of the Board of Governors of the Federal Reserve System. with at least partial success. Citations and a Discount Rate Announcements and Their Ef- fect on Market Interest Rates," Journal of Money. Credit. and Banking, vol. 20, no. 2 (May 1988), pp. 167-180. closed completely. Banks in exigent circumstances that prevent access to market sources of liquidity would run overnight overdrafts, making up the reserve deficiency on succeeding days. Presumably they would also have to pay the penalty for such overdrafts. currently the larger of $50, or the larger of 10% or a rate 2 percentage points above the federal funds rate, in addition 10 making up the deficiency. Inertia in the discount rate is the source of its power, but this poses a danger. By allowing a wide or narrow spread between market rates and an unchanged discount rate to build up over a longer and longer interval, a change in the rate, when it comes, might suggest a major In either case, changes in the discount rate may provide information about the short-run future, affecting rates on securities with maturities longer than innovation in policy thinking. Apprehension of market overreaction could then make a rate-change decision increasingly difficult for the Board of overnight federal funds. Failure to detect information effects uniformly in past discount-rate changes would not disprove the information rationale for Govemors, even though the language of a rate-change announcement can be used to shape its interpretation. On the other hand, changing the rate frequently Cleveland, managing the discount rate. An adverse finding says only that the rate was not managed this way during some time periods in the past or, if it was, that the and in minor amounts to avoid this danger would trivialize the tool into a routine device for rate alignment. Address Correction Requested: result was too small to be detected. Directors' rate recommendations 1. The Banking Act of 1935 created the cur- Federal Reserve Bank of Cleveland Research Department P.O. Box 6387 OH 44101 Please send corrected mailing label to the above address. Material may be reprinted provided that the source is credited. Please send copies of reprinted materials to the editor. BULK RATE U.S. Postage Paid Cleveland, OH Permit No. 385
@FedFRASER