When the Fed implements monetary policy, interest rates are directly affected. There are many different interest rates in the economy (for example, mortgage rates and car loan rates), but this chapter focuses on five key rates:
The federal funds rate can be a little misleading by name. It isn’t a rate the Federal Reserve charges. Instead, it’s the average rate banks charge each other for short-term loans.
These banks are members of the Federal Reserve system. You don’t need the membership details here - just assume member banks are large institutions that help the Federal Reserve carry out monetary policy.
When one member bank lends to another, the average rate charged is the federal funds rate. These loans are usually very short-term (typically overnight). Banks borrow this way to meet reserve requirements if they come up short at the end of the day.
All banks are subject to reserve requirements, which require a certain amount of deposits to be kept in their vaults.
Reserve requirements were created to reduce the possibility of “runs on the bank.” When money is deposited at a financial institution, most of those funds are either lent to other customers or invested. Without reserve requirements, a bank could lend or invest every dollar its depositors gave it. If many customers then tried to withdraw money at the same time, the bank might not be able to meet those requests because the funds would be tied up elsewhere.
By having reserve requirements, these problems are largely avoided (although not completely). To ensure compliance, banks calculate their reserves daily. If a bank lends out too much and falls below its reserve requirement, it will try to borrow from another bank with excess reserves. These loans typically last less than 24 hours. The next day, the bank repays the short-term loan and continues managing its reserves to stay above the required level.
What if a bank needs to borrow to meet reserve requirements, but no other banks are willing to lend? It’s rare, but it can happen. You may have heard about the “credit freeze” during the Great Recession of 2008. With widespread economic stress and large banks like Bear Stearns collapsing, banks became hesitant to lend to one another.
In situations like this, the Federal Reserve can step in. The Fed is sometimes called the “lender of last resort.” A bank can borrow directly from the Fed when it urgently needs funds. The Fed charges the discount rate on these loans.
The discount rate is slightly higher than the federal funds rate, which is why banks typically borrow from the Fed only when they can’t borrow from other banks.
The federal funds rate and discount rate typically influence other interest rates. One of these is the broker loan rate, sometimes called the call money market rate. This rate reflects the cost broker-dealers pay when borrowing from banks.
As a reminder, broker-dealers are institutions that help customers buy and sell securities. Some investors use margin accounts, which allow customers to borrow money for investment purposes (known as leveraging). Broker-dealers aren’t banks and typically don’t have large amounts of cash available to lend. Instead, they borrow from banks and then re-lend those funds to their customers.
The prime rate is the interest rate banks charge their best customers, typically corporations and institutions. Like the broker loan rate, the prime rate is affected by monetary policy because changes in Fed-controlled rates tend to ripple through the rest of the lending market.
The Secured Overnight Financing Rate (SOFR) is a benchmark interest rate. SOFR replaced LIBOR (London Interbank Offered Rate), which was phased out because it relied on banks’ self-reported estimates that could be manipulated and lacked transparency.
SOFR is a broad measure of the cost of overnight borrowing. It’s published daily by the New York Federal Reserve and reflects actual transactional data. SOFR is used as a reference rate for loans, derivatives, and floating-rate instruments, and it can serve as the key reference rate in many financial transactions, including loans, derivatives, bonds, and mortgages.
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