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Federal Funds Rate vs Discount Rate


In 1913 the USA government passed a law, according to which a new Federal Fund becomes an effective central financial support system. The main reason to create such a fund was the need to stop counteraction between responsible banks and set a Federal Funds rate chart.

Functions of the Fed Fund

  1. Execution of the Central Bank’s tasks
  2. The balance between the public interest in the country and the interests of commercial banks (setting Fed discount rate)
  3. Supervision and regulation of the banking system, to protect the interests of investors and customers of credit institutions
  4. Regulation and stabilization of financial markets, risk control
  5. Participation in the current system of international and domestic payments
  6. Elimination of liquidity problems on a local level and the provision of loans to credit institutions

One of the most important functions of the Fed is money issue. Issued money goes mainly to buy US government debt transactions (treasury bills). Only then the bill comes into circulation. Main profit the organization receives thanks to government securities, as well as through international market operations. The bigger part of income is transferred to the government budget.

The Federal funds rate is an interest rate. The government’s banks rely on it when providing loans. The peculiarity of the institution is the following: it is based on a private capital ( not the state one). Any credit institution that meets the requirements of the organization may purchase the shares.

With the Federal Fund rate the CB has an impact on interbank charts both for legal entities and individuals. It is determined at the scheduled meeting of the Federal Committee of the US Federal Reserve. Throughout the year, it is held 8 times, but the committee can carry out additional unscheduled meetings to make changes.

Principle of operation

The amount of the Fed's assets and liabilities of depository institutions determines the level of reserves and the Fed can set it individually. If this level falls below normal, reserves needs to be increases to fit the regulator’s requirements.

To make the interest rates lower, the Federal Open Market Committee increases the currency supply by buying government bonds. And otherwise, if the Committee wants to raise the figures, it sells the bonds thus withdrawing money from circulation.

Many people do not see the difference between the discount rate and federal funds rate. Although, these terms mean not the same.

As far as commercial banks are concerned, if they get loans from the Fund, it is discount rate Fed charges. The rate may be changed at the meeting if necessary. It depends on the state of the US economy. Regarding further decisions concerning changes in figures, there are always discussions and assumptions.

How changes influence the market

The CB of any country has a large number of tools to maintain the currency stability. The excess of any currency on the market can lead to a decrease in the Fed Fund rate chart relative to other currencies. On the other hand, a deficit of the same currency will lead to an increase in demand and in the exchange-value of it. That is why it is important to check the figures daily.

For the Forex market the official interest figures and bank refinancing are the most influential. The reduction in indexes may lead to higher inflation. On the other hand, an increase in interest rates will have a decrease in business activity and appreciation subsequently.

As the basic money supply currency market is concentrated in the US banks, the market is always very sensitive to changes in Fed Fund rate.

A trader must clearly understand the effect of changes in the market. It is an integral part of fundamental analysis and predisposes to the exact entry in and exit out of the market. So, it is better to check Federal reserve discount rate together with other indexes.

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