Discount rate as an instrument of credit control

The Federal Reserve Act authorizes the Reserve banks to rediscount for member banks eligible commercial, industrial, and agricultural paper with a maturity at the time of discount not exceeding 90 days, except that for agricultural paper the maturity limit is nine months, and to make 15-day advances on member bank promissory notes collateraled by obligations of the United States or of Federal Intermediate Credit banks and of the Federal Farm Mortgage Corporation, and 90-day advances secured by commercial, industrial, and agricultural paper eligible for rediscount or purchase by the Reserve banks. This has been interpreted to permit the Reserve banks to make 90-day instead of 15-day advances to member banks since the latter are corporations. Large city banks usually borrow on 1-day notes, while the notes of country banks are of longer maturity but seldom run for 90 days, except in communities with predominantly seasonal business.

"Advances to member banks on the security of direct obligations of the United States are normally for short periods not exceeding fifteen days, and it is not the practice to make advances to others than member banks except in unusual or exigent circumstances." Interest is charged on a discount basis although these loans are called advances.

Eligible paper is defined by the Board of Governors in its Regulation A as follows:

...a negotiable note, draft, or bill of exchange, bearing, the indorsement of a member bank, which has been issued or drawn, or the proceeds of which have been used or are to be used, in producing, purchasing, carrying or marketing goods in one or more of the steps of the process of production, manufacture, or distribution, or in meeting current operating expenses of a commercial, agricultural or industrial business, or for the purpose of carrying or trading in direct obligations of the United States.

It must not be a note, draft, or bill of exchange the proceeds of which have been used or are to be used for permanent or fixed investments of any kind, such as land, buildings or machinery, or for any other fixed capital purpose.

It must not be a note, draft, or bill of exchange the proceeds of which have been used or are to be used for transactions of a purely speculative character or issued or drawn for the purpose of carrying or trading in stocks, bonds or other investment securities except direct obligations of the United States.

Because of the experience of the banking crisis of 19311933, the Federal Reserve Act was amended to authorize the Federal Reserve banks under rules and regulations prescribed by the Board of Governors to make advances up to four months to member banks on their notes secured by collateral satisfactory to the Reserve banks. The rate on such advances must be not less than ½ per cent per annum above the highest discount rate in effect at the time of the advance. Regulation A lists the kinds of collateral that may be accepted for such advances and provides that in addition a Federal Reserve bank may accept as security any assets satisfactory to it, if circumstances make it advisable to do so.

The discount rate is the rate of interest charged by the Reserve banks for rediscounts and advances. Since member bank borrowing is at the initiative of the banks, the discount rate by itself is not a potent instrument for regulating the volume of credit. Raising or lowering the discount rate affects the cost of obtaining additional reserves from the Reserve banks but not the total amount of reserves or excess reserves. While a higher discount rate may discourage borrowing from the Reserve banks -- the banks by tradition are reluctant to borrow from the Reserve banks, anyhow -- a lower rate will not induce the banks to borrow. Changes in the discount rate, however, tend to cause corresponding changes in rates charged by member banks and in open market rates carrying over into the long-term market, which in turn may encourage or discourage borrowing by political entities, business, and consumers. Moreover, changes in the discount rate signal to the institutions of the money market modifications of the Federal Reserve credit policy. An increase in the rate is interpreted as an indication that the Reserve authorities consider the volume of credit overexpanded and are adopting a tighter credit policy, and vice versa.

Furthermore, raising of the discount rate can be an effective means of restricting the volume of credit when it is preceded or accompanied by a rise in reserve requirements or by open market sales on a scale that would force the member banks to borrow from the Reserve banks or to reduce deposits by liquidating loans and investments.

Under these conditions the discount rate became more important as an instrument of credit control. In contrast to open market purchases, which increase reserve balances generally, discounts and advances place reserves immediately and directly in the hands of the individual banks that need them.