Understanding the Federal Reserve, Part Four: Interest Rates

David Frost // Better Investing, Blog


March 9  

This is part four of a series on the Federal Reserve, specifically about interest rates. Click here for part one. Click here for part two on the history. Click here for part three on the Fed’s structure.

One of the most important functions of the Federal Reserve is managing interest rates. There are two main interest rates the Fed adjusts, and these rates impact rates across the U.S. financial industry. The Fed can directly raise or lower the discount rate and make other changes to indirectly impact the federal funds rate.

The discount rate

The discount rate is the rate charged to banks when they take a loan from the Federal Reserve to cover their short-term operating expenses. The Fed’s 12 regional banks handle these short-term loans, which are made to prevent liquidity issues or bank failures and make up for funding shortfalls. The loans are only made for 24 hours or less, and they fall under one of three tiers. 

The primary credit program offers needed capital to banks with a solid credit record and a firm financial footing. The rate is generally a little higher than the current market interest rates available from other banks or short-term creditors. The Fed is meant to serve as a lender of last resort, which is why the discount rate is a bit higher than rates obtained from other sources of capital.

The secondary credit program offers a rate that’s about 50 basis points above the primary rate. Banks which qualify for this tier tend to be smaller than banks which qualify for the primary rate. Their financial situation also may not be as solid as that of banks in the primary tier, which is why they receive a higher interest rate.

The seasonal credit program provides short-term loans to even smaller financial institutions whose cash flows vary even more widely, although they might still be rather predictable. For example, financial institutions which serve a lot of agricultural businesses may fall into this category. This tier includes especially high-risk borrowers. The interest rate for the seasonal credit program is actually based on other rates in the market rather than the discount rate specifically set by the Federal Reserve.  

The federal funds rate

The Fed requires commercial banks to hold a certain level of reserves as cash in their vaults or an account with the Federal Reserve. In most cases, the Fed requires banks to hold 10% of the total value of their demand accounts, which include checking accounts, demand deposit accounts and share draft accounts. Sometimes the Fed may increase or decrease the reserve requirement, making less or more money available for lending.

However, sometimes banks want to finance a major project and don’t want to or can’t afford to wait for interest payments or other payments to come in. Thus, they take out an overnight loan from another bank. They may also take out a loan to keep their reserves where they are legally required to be while also funding projects.

The federal funds rate is the interest rate used on loans made from one financial institution to another. These loans are made overnight, and they are not backed by collateral. Because the Fed does not directly set this rate, there are actually two variants of it. 

The members of the Federal Open Market Committee (FOMC) set the federal funds target rate, which is the rate they want to see in the market. To achieve the target rate, the Fed must make other adjustments through the financial system. When news outlets report that the Fed is changing interest rates, they are usually referring to the federal funds target rate. 

The federal funds effective rate is the weighted average of interest rates on actual interbank loans being made in the market. 

How the Fed adjusts the federal funds target rate

Through open market operations, the FOMC pulls various levers to move the federal funds effective rate toward the target rate. The levers the FOMC uses impact how much capital is available for lending, which then impacts the interest rates that are charged. Each lever sends ripple effects through the economy. The more capital is available, the lower the interest rate is. On the other hand, if the Fed tightens the capital supply, interest rates increase because there is less money available to lend.

By lowering interest rates, the Fed makes more money available, making it easier for businesses and consumers to borrow money. When businesses borrow money, it enables them to expand and hire more workers, which then reduces unemployment. 

If it looks like the economy is slowing, the Federal Reserve may decide to cut interest rates to help spur it along. On the other hand, if it looks like the economy is roaring ahead of itself, the Fed may raise interest rates to help slow things down. The Fed may choose to do this if it looks like the economy is overheating or inflation is rising too fast. 

Another way the Fed adjusts the amount of money that’s available in the market is by selling or purchasing government bonds and other securities. The federal funds rate declines when the supply of available money increases, which occurs when the Fed buys government securities. On the other hand, if the Federal Reserve wants to tighten the money supply, thereby increasing the federal funds rate, regulators will send sell orders for government securities, which removes the money they earn on those sales from circulation. 

How the Fed affects other interest rates

The Fed can also impact asset prices by adjusting interest rates. When the central bank cuts rates, it means yields on government and corporate bonds fall, which makes them less attractive to investors. As a result, investors tend to pull more money out of bonds and place it in stocks instead, so lower interest rates often mean a stock market rally. 

There is another interest rate that it’s important to understand, along with how the Fed can impact it by changing the federal funds rate. Raising the federal funds rate typically results in an increase in the prime rate, also known as the Bank Prime Loan Rate. The prime rate is the rate the best borrowers receive when taking out a loan from banks or other financial institutions. All other consumer interest rates are based on the prime rate, which means customers who don’t have the best credit will receive an interest rate that’s a set amount of basis points higher than the prime rate. 

Interest rates for credit cards are also based on the prime rate. Additionally, interest rates for money market accounts or certificates of deposit change based on changes in the prime rate. Higher interest rates should mean that consumers save more money because they’re getting a higher return on their money and because it costs them more to borrow money.

Mortgage rates are also linked to the prime rate, so when interest rates fall, homeowners may refinance their mortgages so they can get a lower interest rate. On the other hand, home sales may fall when interest rates increase because consumers can’t or aren’t in a rush to pay the higher interest rate.

About the Author

Trading and investing in markets is second nature to some, but a mystery to others. The goal is to provide a forum where everyday people aspiring to be part time or full time traders will learn how view markets differently and profit beyond their wildest dreams.

David Frost