A Change in a Policy Tool

On May 17, the Board of Governors of the Federal Reserve announced a proposal to change the nature of its discount rate and the use of the discount window lending of reserves to banks. The proposed changes will not take effect until after a 90-day comment period.

The changes are not changes in the direction of the current monetary policy, but are intended to increase the effectiveness of all of its tools. If the changes are adopted, the most important differences will be that the discount rate will be set at a level above the target federal funds rate (initially at one percent above) and that banks will no longer be discouraged from borrowing reserves directly from Federal Reserve banks. As a result, it is likely that banks will borrow more reserves from the discount window when the federal funds rate does rise significantly above the target rate and thus the actual federal funds rate will not fluctuate as much in response to short-term changes in supply and demand for reserves.

Several other aspects of the proposal are technical in nature and are not essential to a fundamental understanding of monetary policy and its tools.