Please clear this up for me.
This is how I understand it. The discount rate and the federal funds rate are two different rates. The Fed controls the discount rate. This in turn affects most other interest rates including the federal funds rate.
Is my understanding incorrect?
Here is a concise primer on the Fed’s monetary policy tools.
They are indeed two different rates. Discount rate is the interest charged for banks to borrow from Federal Reserve banks. As you said, this is directly controlled by the Fed. It simply sets this rate for the Reserve system.
The federal funds rate is a market rate for on the overnight borrowing of reserves by one bank from another. By the Reserve system, each bank has to keep some funds on reserve, and this value will change day to day depending on the transaction. If one bank requires reserve funds on a short-term basis, it can opt to borrow from another bank that has more in reserve than required. The interest rate on this borrowing of reserves is called the funds rate.
The Federal Open Market Committee influences the funds rate by buying and selling government securities. If it buys securities, the selling bank gains cash in reserve and can thus loan out more - the supply of reserves increases, and the fund rate falls. If it sells securities, the supply of reserves decreases, the fund rate rises.
I don’t think change in the discount rate will significantly affect the funds rate. The Open Market Committee must take action in securities trade to influence the funds rate. On the other hand, changes in the discount rate and the funds rate are typically coordinated. The Fed can set target goals for the funds rate and makes securities transactions accordingly to adjust the the rate as desired. This way, there can be a cohesive monetary policy to either expand or constrict the money supply as needed.