The "discount rate" is the interest rate that a regional Reserve Bank charges banks and financial institutions when they borrow funds on a short-term basis. The Fed discourages banks from borrowing except for occasional, short-term emergency needs.
The discount rate often plays a larger role in the overall monetary policy than would be expected because it is a visible announcement of change in the Fed's monetary policy. Typically, higher discount rates indicate that more restrictive monetary policies are in store, while a lower rate might signal a less restrictive move.
Changes in the discount rate can affect:
- Lending rates (by making it either more or less expensive for banks to get money to lend or hold in reserve)
- Other open market interest rates in the economy (because of its "announcement effect")