The key rate is the interest rate charged to banks when they borrow funds from other banks or from the Federal Reserve, which is the central bank of the U.S.
When banks lend money to each other, the key rate is known as the federal funds rate. When the loan comes directly from the Federal Reserve, it's called a discount rate.
These loans are usually short term and used to bolster a bank's reserves.
Who sets the key rate?
The federal funds rate discount rates are set by the Federal Open Market Committee (FOMC), which is the policy-making body of the Federal Reserve. The FOMC meets several times a year to set the rates, so they’ll fluctuate throughout the year according to the committee's current monetary policy.
Why do banks borrow from each other?
Borrowing between banks is common practice, and these short-term (often overnight) loans are necessary when a bank's reserves are too low.
Most financial institutions are required to keep a specific amount of money in their reserves at all times. This amount is called the reserve requirement. The reserve requirement ensures that financial institutions have enough liquid assets to meet customer withdrawals at all times.
If too many customers were to withdraw money while the reserve is below the requirement, the bank wouldn’t have enough funds to complete the transactions. To avoid this scenario, banks lend money to each other or borrow from the Federal Reserve whenever their reserves dip too low.
The impact of key rates on consumers
When the Federal Reserve raises key rates, banks increase prime lending rates, which are the interest rates charged to most creditworthy customers.
The prime rate is typically three percentage points higher than the key rate at any given time, and it applies to credit cards, mortgages, personal loans and more. When interest rates rise, fewer people use their credit cards or apply for loans.
That being the case, the Federal Reserve uses key rates to influence the economy. When rates are higher, consumer spending dips, reducing the overall flow of money in the economy. On the other hand, when the Federal Reserve reduces the key rate, banks’ prime rates dwindle and consumers are more likely to use their existing lines of credit and apply for loans, increasing consumer spending and bolstering the economy.
Why does the Federal Reserve raise or lower key rates?
The Federal Reserve, also known as the Fed, changes key rates to control the flow of money in the economy. Decreasing them is an expansionary monetary policy that leads to lower interest, encouraging consumer spending. Conversely, raising key rates is a contractionary measure that makes it more expensive for consumers to borrow from banks.
The Fed monitors the economy throughout the year to create monetary policies involving key rates and other economic control aspects. The agency often changes key rates to correct or avoid distortion, which can cause inflation or, on the other hand, a recession. Either situation can devastate the economy, so the Fed employs these strategies to keep the economy on an even keel and employment rates stable.