When the Fed implements monetary policy, interest rates are directly impacted. There are many different interest rates in the economy (e.g., mortgage rates, car loan rates), but we’ll specifically focus on these five rates in this chapter:
The federal funds rate has a misleading name. Although it sounds like the Federal Reserve’s rate, the federal funds rate is the average rate banks charge when lending to other banks. Granted, these banks are considered members of the Federal Reserve system. You won’t need to know what it takes to be a part of the Fed’s system, but assume member banks are large institutions that help the Federal Reserve carry out monetary policy.
When a member bank lends money to another member bank, the average rate charged is known as the federal funds rate. Member banks typically borrow money for very short periods (usually overnight) to meet reserve requirements if they fall 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 out to other customers or invested. Without reserve requirements, a bank could lend out or invest every dollar its depositors gave it. If many customers went to the bank to request a withdrawal, the bank couldn’t fulfill those requests if all the money was locked up in other expenditures.
By having reserve requirements, these problems are largely avoided (although not completely). To ensure compliance with this rule, banks calculate their reserves daily. If a bank lends out too much money and falls below its reserve requirement, it will attempt to borrow from another bank with excess reserves. These loans typically last less than 24 hours. The following day, the bank will repay its short-term loan and move to keep its reserve levels above its requirements.
What if a bank needs to borrow money to meet reserve requirements, but no banks are willing to lend? It’s rare, but it happens. You may have heard about the “credit freeze” in the Great Recession of 2008. With many economic problems and large banks like Bear Stearns collapsing, banks hesitated to lend. When this occurs, the Federal Reserve steps in to help.
The Fed is sometimes called the “lender of last resort.” A bank can go to the Fed if it desperately needs to borrow money. The Fed charges the discount rate as its own interest rate. The discount rate is slightly higher than the federal funds rate, which is why banks go to the Fed if no other bank is willing to lend.
The federal funds and discount rate typically influence other rates. One of those rates 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 their customers buy and sell securities. Sometimes investors utilize margin accounts, which allow customers to borrow money for investment purposes (known as leveraging). Broker-dealers aren’t banks and don’t have significant amounts of cash to lend, so they go to banks to borrow money and re-lend to their customers.
The prime rate represents the interest rate banks charge when lending to their best customers, typically corporations and institutions. Like the broker loan rate, the prime rate is affected by monetary policy as Fed actions tend to trickle downwards.
The Secured Overnight Financing Rate (SOFR) is a benchmark interest rate. SOFR replaced LIBOR (London Interbank Offered Rate), which was phased out. SOFR is a broad measure of the cost of overnight borrowing. The SOFR is published daily by the New York Federal Reserve, and it reflects actual transactional data for reference rates for loans, derivatives, and floating-rate instruments. SOFR can provide the key reference rate used in various financial transactions, including loans, derivatives, bonds, and mortgages.
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