The Key Rate Demystified for Enhanced Financial Decision-Making
The key rate is the specific interest rate that dictates bank lending rates and the credit cost for borrowers. In the United States, two principal interest rates serve this function: the discount rate and the federal funds rate. These rates, set by the Federal Reserve either directly or indirectly, influence lending practices, the supply of money, and the economic credit environment.
Key Takeaways
- The key rate determines lending rates for banks and the cost of credit for borrowers.
- Two primary key rates in the U.S. are the discount rate and the federal funds rate.
- The key rate influences the rate at which banks borrow to maintain reserve levels.
- The Federal Reserve uses the key rate to expand or contract the national economy.
Understanding the Key Rate
The key rate governs the interest rate at which banks can borrow when they need to make up for shortfalls in their required reserves. Banks borrow from other banks or directly from the Federal Reserve for very brief periods. When banks borrow from each other, the applied interest rate is known as the federal funds rate. For borrowing directly from the Federal Reserve, the discount rate applies.
During times of significant withdrawals by account holders, a bank may encounter liquidity issues, meaning it lacks sufficient funds to meet withdrawal requests. This is intrinsic in the fractional reserve banking system, where banks are mandated to keep only a small portion of deposits in reserve. Consequently, individuals storing large amounts of money in a bank should consider how current reserve levels may affect the amount of cash that can be withdrawn at any given time.
Strategic Considerations for Financial Planning
Key rates are pivotal tools employed by the Federal Reserve to implement monetary policy. To foster economic expansion, the Federal Reserve can increase the money supply by purchasing bonds on the open market, guided by the federal funds rate. Conversely, to contract the economy, the Federal Reserve raises interest rates, thereby increasing borrowing costs.
Controlling the money supply is achievable by adjusting the key rate, which subsequently affects the prime rate—the standard rate banks offer to high-creditworthy customers. Generally, the national prime rate is roughly 3 percentage points above the federal funds rate. Therefore, any shift in the fed funds rate influences banks’ prime rates and, subsequently, consumer loan rates, including mortgages and credit cards.
An increase in key rates raises consumer borrowing costs, prompting higher savings rates and reduced consumer spending, contracting the economy. In contrast, lowering key rates lowers borrowing costs, encouraging spending over savings, thereby expanding economic activity.
Diverse Types of Key Rates for Financial Analysis
The federal funds rate is the rate banks impose on each other for overnight loans, used to satisfy reserve requirements. This rate regulates overnight lending among financial institutions, including private-sector banks and credit unions. When banks borrow directly from the Federal Reserve, they’re charged the discount rate instead.
The Federal Reserve sets the discount rate; higher rates discourage bank borrowing due to elevated costs, leading banks to retain reserves and limit lending to businesses and individuals. A reduced discount rate, however, reduces borrowing costs for banks, encouraging increased lending and more frequent borrowing to meet reserve requirements.
Related Terms: discount rate, federal funds rate, required reserves, monetary policy, prime rate.
References
- St. Louis Fed. “Bank Prime Loan Rate Changes: Historical Dates of Changes and Rates”.
- Federal Reserve Bank of New York. “Effective Federal Funds Rate”.
