What Is the Key Rate?

What Is the Key Rate?

Let me explain the key rate directly to you—it's the specific interest rate that sets the tone for bank lending rates and the overall cost of credit for borrowers like yourself. In the U.S., the two primary key interest rates are the discount rate and the federal funds rate, which the Federal Reserve sets either directly or indirectly to shape lending practices and the flow of money and credit throughout the economy.

Key Takeaways

You should know that the key rate directly impacts lending rates for banks and the credit costs you face as a borrower. It includes two types: the discount rate and the federal funds rate. This rate dictates how much banks pay to borrow funds to keep their reserve levels in check. Ultimately, the Federal Reserve uses it to steer borrowing costs, either expanding or contracting the national economy as needed.

Understanding the Key Rate

Think about this: the key rate is what banks pay in interest when they're short on required reserves. They can borrow from other banks or straight from the Federal Reserve, but only for a short time. The rate for borrowing between banks is the federal funds rate, while borrowing from the Fed comes at the discount rate.

If a lot of account holders suddenly pull their money out, a bank might run into liquidity problems or not have enough cash on hand. That means you might not get all your money right when you ask for it, because under the Federal Reserve's fractional reserve system, banks only hold a small portion of deposits as cash—this is the reserve requirement.

Important Note

Here's a key point for you: when you're keeping large sums in a bank, remember that their current reserves could limit how much cash you can withdraw at any one time.

Special Considerations

Key rates are a primary tool for the Federal Reserve in carrying out monetary policy. When they aim to boost the money supply, they'll buy bonds on the open market with new money, using the federal funds rate to decide the scale and pace of those purchases. In a contractionary mode, they hike rates to make borrowing more expensive.

The Fed controls the money supply by tweaking the key rate, since the prime rate—which banks use as a benchmark for consumer loans—follows it closely. Typically, the national prime rate sits about 3 percentage points above the fed funds rate. If the fed funds rate rises after a discount rate increase, banks adjust their prime rates, which then pushes up rates on things like mortgages and credit cards for you.

When key rates go up, borrowing gets costlier for consumers, so you might save more and spend less, leading to economic contraction. Lowering them reduces borrowing costs, encouraging less saving and more spending, which expands the economy.

Types of Key Rates

The federal funds rate is what banks charge each other for loans to meet reserve requirements, specifically for overnight lending to private banks, credit unions, and similar institutions. If a bank borrows directly from the Federal Reserve, it pays the discount rate.

The Fed sets the discount rate itself. Raise it, and banks hesitate to borrow because costs are higher, so they build reserves and lend less to people and businesses. Lower it, and borrowing becomes cheaper, prompting banks to lend more and borrow what they need to hit reserve levels.