In a largely symbolic move The Fed yesterday increased the Discount Rate from 0.50% to 0.75%. Historically the Discount Rate is one of three main policy tools used to manipulate monetary policy.

The move is considered symbolic as it’s an indicator of things to come. In and of itself the move has no meaningful economic impact.

To understand why let’s review the three policy tools:

(1) Open Market Operations (“OMO”) is the preferred Fed method. It involves adding system-wide liquidity through The Fed’s purchase of securities from commercial banks and, conversely, draining liquidity through the sale of securities to commercial banks. OMO is conducted daily at 11:00am through the NY Fed and ratcheted up or down as liquidity requirements vary.

(2) The Reserve Requirement is rarely changed by The Fed. It entails manipulating the minimum amount of deposits that must remain at commercial banks (e.g. $0.20 of every $1) and cannot be loaned to customers demanding credit. Reasons for infrequent use include powerful effects on the banking system and the requirement that changes be publicly announced.

(3) The Discount Rate is the cost to commercial banks of borrowing from The Fed for emergency loans. It is largely symbolic as banks seeking excess liquidity prefer to borrow from other banks in the form of overnight loans known ironically as Fed Funds.

Historically when The Fed seeks to manipulate monetary policy it increases or decreases the target Fed Funds Rate. (Although they do not directly set this rate they announce a preferred target for commercial banks to follow.) This is what we hear about when it’s reported The Fed has “raised rates.” Typically when the target Fed Funds Rate is changed the Discount Rate moves in a similar fashion yet because commercial banks prefer borrowing from one another (Fed Funds) than from The Fed (Discount Rate) the move is considered symbolic.

Yesterday’s rate increase is symbolic for a different reason. The Discount Rate is typically set 0.50% higher than the target Fed Funds Rate. Over the past year or two this spread has been smaller (and, at times, non-existent) as the stigma of emergency borrowing from The Fed was outweighed by the real or perceived instability in the banking system.

What yesterday’s move did was twofold – it encourages commercial banks to seek private rather than public sector funding (i.e. borrow from investors or one another instead of The Fed) and it signals The Fed’s first step in what will be a long series of future moves designed to take the patient off life support.