Rates

When the Fed implements monetary policy, it directly affects interest rates. There are many interest rates in the economy (for example, mortgage rates and car loan rates), but this chapter focuses on four key rates:

• Federal funds rate
• Discount rate
• Broker loan rate
• Prime rate

Federal funds rate

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 Fed carry out monetary policy.

When one member bank lends to another, the average interest rate on those loans is the federal funds rate. These loans are usually very short-term (often overnight) and are commonly used to meet reserve requirements.

Reserve requirements are rules that require banks to keep a certain amount of deposits on hand as reserves. The idea is to reduce the risk of a “run on the bank.”

Here’s the basic problem reserve requirements are designed to address:

• When customers deposit money, banks typically lend or invest most of it.
• If a bank lent or invested every dollar it received, it might not have enough cash available if many customers tried to withdraw at the same time.

Reserve requirements help reduce this risk (although not completely). To stay in compliance, banks calculate their reserves daily. If a bank ends the day below its required reserve level, it may borrow from another bank that has excess reserves. These loans typically last less than 24 hours. The next day, the borrowing bank repays the loan and works to keep its reserves above the required level.

Discount rate

What if a bank needs to borrow to meet reserve requirements, but no other bank is willing to lend? It’s rare, but it can happen. For example, during the “credit freeze” in the Great Recession of 2008, banks became hesitant to lend amid widespread economic stress and major failures like Bear Stearns.

In situations like this, the Federal Reserve can step in. The Fed is sometimes called the “lender of last resort” because a bank can borrow directly from the Fed when it can’t obtain funds elsewhere. The interest rate the Fed charges on these loans is the discount rate.

The discount rate is typically slightly higher than the federal funds rate. That difference helps explain why banks usually prefer borrowing from other banks first and go to the Fed only when needed.

Broker loan rate

The federal funds rate and the discount rate often influence other interest rates. One of those 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 help customers buy and sell securities. Some investors use margin accounts, which allow them to borrow money to invest (this is called leveraging). Broker-dealers aren’t banks and generally don’t have large pools of cash to lend. Instead, they borrow from banks and then re-lend those funds to customers who are buying on margin.

Prime rate

The prime rate is the interest rate banks charge when lending to their best customers, typically corporations and institutions. Like the broker loan rate, the prime rate is influenced by monetary policy because changes in Fed-controlled rates tend to ripple through the financial system.