The discount rate

Let's do a little review of what the Fed funds rate was. And then we can move into something that you've probably heard in the same context, and they're often confused, and that's the discount rate. And they are related and they kind of do move together. They are pretty different in their actual implementation. So the Federal funds rate-- this is a target rate. This is the target rate at which the Federal reserve wants banks to lend to each other. So let's say that I have-- and I won't draw the balance sheets every time now-- let's say I have have Bank One and this is Bank Number Two. And let's say this bank over here has a surplus of reserves. I was already using green, but I'll do that in gold just so we can reminisce about the gold standard. So let's say it has a surplus of reserves and Bank Two needs them, right? And let's say right now that Bank One is willing to lend it to Bank Two if Bank Two pays Bank One a 6% overnight rate. And let's say that the Federal reserve, they say, you know what? That's above our target rate. We want banks to lend to each other for a lower interest rate, so we want to do open market transactions or open market operations to lower this rate. And the mechanics that they do it by-- let's draw the Fed's balance sheet. I'll do them in magenta. That's half of it and then this is the other half. So let's say that this is the Fed's current assets-- and in a couple of videos, I'll actually show you what the Fed's balance sheet looked like before all this craziness started and what it looks like now, but that's the Federal reserve's assets. This is their liabilities. And then their liabilities are going to be a little bit smaller then their assets and they have a little equity. Their equity's a little different than traditional equity. There really isn't a lot of upside. You just get a dividend on it, but we won't go to details there. But the mechanism that the Fed uses to do these open market operations is they essentially print money. So what the Federal reserve will do is, they will create some notes or some actual reserves. So these are Federal reserve notes-- or as we know them, the dollar bills that are sitting in your wallet or the things that could be converted to dollar bills that are sitting in your bank account, the bits and bytes in some computer database someplace. And they can't create it out of thin air. They have to have an offsetting liability and their offsetting liability are Federal reserve notes outstanding. This is just saying, hey, we issued this. If someone comes back to us, we have this liability. And this is issued even though these Federal reserve notes-- I'll circle it in yellow-- are issued by the Federal reserve bank. They're backed by the full faith and credit of the U.S. government. We've talked a lot about what that means, but needless to say, we're just going over the mechanics. So what they'll do is they'll take these dollars now and they'll use these dollars to go buy treasuries from people out in the world. It could be me. It could be my grandfather. It could be even some of these banks and so let's say that there's-- right now somebody is holding a treasury. I hold a T-bill. The Federal reserve will use that money-- let's say I own a ton of T-bills. I'm the richest man in the country. I could even be China. China holds a lot of T-bills. They buy the T-bill. So then this becomes-- this asset is no longer Federal reserve notes. It's now a T-bill. And then I'm no longer holding a T-bill, right, because I sold it to the Federal reserve bank. I don't know I sold it to the Federal reserve bank. I just sold it in the market. I don't know who bought it. It might have been another guy. It might have been another country. But it happened to be in this case the Federal reserve bank. And now I'm holding reserves. I'm holding money as we know it. I'm holding a Federal reserve note. And what am I going to do with that Federal reserve note? I'm going to deposit it in banks, right? And so I'm going to take this Federal reserve note. Let's say I have a couple of bank accounts. Just for the sake of simplicity, I deposit some of it in this bank account and let's say I deposit some of it in this bank account, just for simplicity. So what happens now? Now this guy has more notes to lend out and this guy needs less. So demand has gone down. This guy needs less. So demand has gone down from this guy. And supply has gone up from this guy. We know that if you need something less, but people have more of it, the price of buying it or borrowing it is going to go down. So this guy has more of it and this guy needs it less, all of a sudden this guy's not willing to pay 6% to borrow it. And this guy's actually more desperate to offload some of these reserves and get some interest on it. So this guy's going to lower the rate he'll charge and this guy's going to lower the rate he's willing to pay and maybe it goes down to 5%. And the Federal reserve can keep buying or selling treasuries to adjust what this happens. They could do the opposite. If they said, wow, rates are a little bit too low. Let's say whatever happens, rates are at 3% and the Federal reserve doesn't like that and wants to raise the Federal funds rate, which is the target rate that banks lend to each other, then they can do the opposite thing. They could take this T-bill, right? This was a T-bill. And they'll sell it, right? So they'll take this T-bill and they'll sell it to someone else-- maybe this guy right here. So this guy, he's got a dollar bill. So his dollar bills are going to be sitting at one of these banks. Let's say his dollar bills are sitting at one of-- he's got a couple there and couple there. So when the Federal reserve sells this T-bill to this guy, this guy might do a wire transfer to that party-- or a check or it doesn't matter, but either way you look at it, these reserves disappear and they go back into the Federal reserve. When they go back into the Federal reserve, they offset this liability and then the currency essentially disappears, but the real result is that all of a sudden then demand would have gone up because there'd be fewer reserves in the system. Demand goes up. And then the supply would have gone down because there's also fewer reserves in the system. And now this guy, he's like, wow, I have less to lend out. I need more interest in order for me lend it out. And this guy says, wow, I'm more desperate than ever to borrow some reserves. I'm willing to pay more and so the rates will go up to 4%. Now all of this works well assuming a world where banks are willing to lend to each other at some rate. There's some rate at which this guy says, I'm willing to lend to this guy because I know he's going to pay me the next day and it's just a matter of just supply or demand. These tend to be overnight loans. They tend to be very short term loans so they tend to be very, very safe, but what happens in a world-- let me draw the same two banks. I think I overdrew. So this is Bank Number One and this is Bank Number Two-- and Bank Number One had more reserves. Bank Number Two has fewer. Bank Number Two needs reserves. Let's say people are worried about Bank Number Two. All of their depositors are starting to get scared and they're starting to pull their reserves out, right? And we all know that these banks don't keep enough reserves to fulfill all of their deposits. Actually, let me draw Bank Number Two's balance sheet. They have equity, hopefully. They'll have some deposits. Let's say all of these are deposits. They have to keep some reserves, right, so that's an asset. Depending on their reserve requirements, but they'll have some reserves in case people want to take out their money from their checking accounts-- and then the rest of these are assets that they invested in and the bank makes money by making more money on these assets than it has to pay out in interest. It makes money on that spread. Now what happens if this bank-- its condition starts to get a little bit weak, people start to get afraid, and the deposits start to-- people go to their ATM, start pulling their money out, and if anything maybe they'll start depositing it into a safer bank or just stuffing it under their mattresses, right? This bank says, all of a sudden I have a liquidity issue because, sure, maybe that much people withdraw their money. I have enough reserves to pay that, but then if another guy comes along, that's going to deplete my reserves and then when the next guy comes along, I'm not going to have any reserves left and it's going to be a full all-out panic when I-- I told this guy that I could give him his money on demand and all of a sudden, if I can't give him on demand, then we're going to have this huge banking panic and then everyone else is going to want their deposits and then I'm going to have this huge liquidity crisis. In a normal situation like that, I'd say, hey, Bank Number One, I need some reserves and just like I did in the first half of this video, this guy would lend the reserves and then this guy would give this guy interest. But what if this guy is scared of Bank Number Two too? He's like, wow, that guy's in a tough situation. He's facing a liquidity crisis. I don't even know what his assets are worth. Maybe his assets are actually shrinking. And that's been happening lately. Maybe he made a bunch of bad mortgage loans. I don't want to lend to this guy. And this guy becomes a pariah of the banking community. No-one wants to lend to this guy. But at the same time, it's in no-one's interest for there to be a run on this bank. Because if this guy can't pay one of his depositors-- and this is kind of a prime weakness of a fractional reserve system. If there's just one weak link in the banking system and people lose confidence-- maybe this guy was the only bad bank out there and people start taking all their money out. The first guy who can't get his money back, he's going to call up the press and say, my God, the banks aren't good for the money. Maybe there's a run on all the banks because people don't know which banks are good, which ones are bad. So to prevent this, the Federal reserve has something called the discount window. So let me draw the Federal reserve's balance sheet again. And the discount window is essentially a lender of last resort to the banks. So there's some type of Federal funds rate. Let's say the Federal funds rate is at 6%. In a normal environment, this guy would lend to get back at 6%. But let's say that's broken and this guy is really desperate. He can actually go to the Federal reserve and borrow directly from the Federal reserve. So once again, these are the assets of the Federal reserve. These are the liabilities. This is the equity of the Federal reserve. And the Federal reserve in this situation now, they'll print notes-- so Federal reserve notes or reserves, either way-- and these are the notes outstanding liability. And they will lend it to this guy. They'll lend these notes to this guy and in exchange, this guy has to give some collateral to the Federal reserve. So let's say he had some other assets here that are hard to sell. He didn't want to sell them in a hurry. So he'll just keep it as collateral with the Federal reserve. And these are called repurchased transactions. It's essentially just-- you're collateralizing a loan-- and I'll do a whole video on what a repo transaction is, but the big picture is, this guy is desperate. No-one else is willing to lend him money so the Federal funds rate is now a non-issue. So he goes to the discount window and borrows directly from the Federal reserve as a lender of last resort. And the rate at which he borrows-- the interest that he pays this guy, that is the discount rate. So that's the rate that a bank pays to the Federal reserve when it can't borrow from another bank overnight. And in general, the discount rate tends to be higher than the Federal funds rate. In fact, it always is, right? Because if the discount rate was less than the Federal funds rate, then you'd always have people using the discount window all of the time instead of borrowing from each other. But we'll see in future videos, when times get tough, this gets used a lot more. Historically the discount rate was about a percent higher than the Federal funds rate to encourage people to lend to each other or borrow from each other, but in the recent past that spread is gone down and now all of the rates are almost zero, but we'll go into that in more detail, but it's a key differential. When the Federal reserve talks about setting rates, they're usually talking about setting the Federal funds rate and the discount rate usually moves down with it, but it's always going to be a little bit higher than the Federal funds rate. This is for lending of last resort. This is for everyday borrowing between banks to make sure that everyone has the reserves they need or they don't have too much and they can get interest on it. Anyway, see you in the next video.