Interest Rates – Fed Fund Rate, Fed Discount Rate, Prime Rate, CD Rate
There is so much talk about interest rates and speculation about what the Fed (Federal Reserve Bank) is going to do and whether the Fed is going to raise interest rates in the near future.
There are so many terms tossed in the air – “Fed Fund Rate”, “Fed Fund Target Rate”, “Effective Fed Fund Rate”, “Fed Discount Rate” in the financial news.
What do all these rates mean? How does this affect you? I will try my best to demystify interest rates in this post.
Bank Reserve Requirement
Banks (aka depository institutions) are expected to maintain a certain level of mandatory reserves in the Federal Reserve Bank. If one bank has more than the required mandatory reserves, then it could lend from the surplus reserves to another bank that is short on meeting the mandatory federal reserve requirement.
The rate at which banks lend to each other is governed by the Fed Fund Rate.
Fed Fund Rate
In the United States, the Fed Fund Rate or the (Fed Fund Target Rate) is the interest rate at which the Federal Reserve System desires financial depository institutions (mainly banks and credit unions) to lend to each other from their federal reserves overnight with no collateral.
The Fed Fund Target Rate is a typically a range. The current target range is 0.25% to 0.50%.
The governors from the 12 Regional Federal Reserve Banks meet 8 times a year (approximately every six weeks) in the Federal Open Market Committee (FOMC) to discuss the health of the economy and make economic policy decisions and determine the Fed Fund Rate.
Effective Fed Fund Rate
The Effective Fed Fund Rate is the effective rate at which banks negotiate and lend to each other from their reserves overnight with no collateral.
The current Effective Fed Fund Rate is 0.40% as of 08/30/2016.
How does the Fed ensure that the “Effective Fed Fund Rate” is within the Fed Fund Target Rate range?
The Fed controls the money supply and has several knobs / levers it could turn.
The Fed could pump money (print money) into the banking system by purchasing Fed backed securities like treasury bills and increase the money supply in banks or sell the securities to reduce the money supply.
Whenever the Fed purchases securities, it is making open market purchases, and this results in bringing more money into circulation and into the banking system. When the Fed sells securities, the opposite happens and money supply tightens.
When money supply increases, the cost of borrowing goes down. It promotes lending.
When money supply decreases, the cost of borrowing goes up. It discourages lending.
Thus the Fed is able to regulate the Effective Fed Fund Rate – aka the rate at which banks lend to each other.
A bank may be interested in financing a major business loan. Let us say this bank needs to raise money to finance this major business loan.
If the Fed Fund Rate is low, it will be keen on borrowing money from another bank and proceed with financing the major business loan.
However, if the Fed Fund Rate is high, bank would become reluctant in financing the business given that it has to borrow from another bank at a higher rate.
Fed Discount Rate
The Fed Discount Rate is the interest rate charged by the Federal Reserve Bank to banks (depository institutions) on the loans given to them from the Federal Reserve Bank.
There are three discount programs offered by the Federal Reserve Bank – primary credit, secondary credit, and seasonal credit – each of these have their own interest rates.
As it stands at the time of this writing, the Fed Discount Rate is 1.00% for primary credit.
The Fed Fund Rate and Fed Discount Rate go up and down in tandem with each other.
Certificate of Deposit Rates
The is the interest rate you get when you open a Certificate of Deposit (CD) with a bank. The CD rates generally go up and down alongside the Fed Fund Rate.
Sometimes, banks may not increase the CD rates in lock step with the Fed Fund Rate increase. In such instances, the banks are pretty much increasing their profits.
However, generally, as the Fed Fund Rates go up, you can expect the CD rates to go up as well.
Below is a chart that shows the Fed Fund Rate vs. CD Rate history.
Image Source / Courtesy: Bankrate.com
The prime rate or the prime lending rate is the interest rate at which banks lend to their favorite customers – basically customers with excellent credit.
The current prime rate, according to Wall Street Journal’s bank survey, is 3.5% at the time of this writing.
As a general rule of thumb, the prime rate is typically ~3% more than the current Fed Fund Rate.
How Do Banks Make Money?
The banks have deposits in checking accounts that virtually yield next to nothing these days.
The CDs rates are in the ~1% range.
The prime rate is ~3.5%.
The bank keeps the spread – that is their bread and butter.
Of course, there are overdraft fees, ATM fees, and every other fee that you come across.
Interest Rate Speculation
When it comes to speculating interest rates and what the Fed will do, there are two kinds of people:
#1 People who know that they don’t know what the Fed will do.
#2 People (speculators) who don’t know the fact they don’t know what the Fed will do.
My opinion is to not sit and wait for the Fed. One must always take a balanced investment approach.
How Does Fed Fund Rate affect you?
As you see, at the very minimum, the Fed Fund Rate affects your borrowing interest rate and your CD rates.
In a rising interest rate environment, money supply gets tighter as rates go up.
Hence, rising interest rates curb inflation, and people spend less because, the borrowing costs are expensive.
Businesses don’t make huge investments since financing becomes expensive in a high rate environment, which impacts their future growth / earnings.
In general, the following statements are true, but there are always exceptions:
#1 As interest rates go up, historically stocks go down and vice versa.
#2 Bond prices go down as interest rate goes up and vice versa.
What questions do you have about interest rates? I would love to hear your feedback / questions. If you enjoyed reading this post, please share it in social media.