Subject: Regulation - Federal Reserve and Interest Rates

Last-Revised: 25 Apr 1997
Contributed-By: Jeffrey J. Stitt, Himanshu Bhatt, Nikolaos Bernitsas, Joe Lau

This article discusses the interest rates which are managed or influenced by the US Federal Reserve Bank, a collective term for the collection of Federal Reserve Banks across the country.

The Discount Rate is the interest rate charged by the Federal Reserve when banks borrow "overnight" from the Fed. The discount rate is under the direct control of the Fed. The discount rate is always lower than the Federal Funds Rate (see below). Generally only large banks borrow directly from the Fed, and thus get the benefit of being able to borrow at the lower discount rate. As of April 1997, the discount rate was 5.00%.

The Federal Funds Rate is the interest rate charged by banks when banks borrow "overnight" from each other. The funds rate fluctuates according to supply and demand and is not under the direct control of the Fed, but is strongly influenced by the Fed's actions. As of April 1997, the target funds rate is 5.38%; the actual rate varies above and below that figure.

The Fed adjusts the funds rate via "open market operations". What actually happens is that the Fed sells US treasury securities to

banks. As a result, the bank reserves at the Fed drop. Given that banks have to maintain at the Fed a certain level of required reserves based on their demand deposits (checking accounts), they end up borrowing more from each other to cover their short position at the Fed. The resulting pressure on intrabank lending funds drives the funds rate up.

The Fed has no idea of how many billions of US treasuries it needs to sell in order for the funds rate to reach the Fed's target. It goes by trial and error. That's why it takes a few days for the funds rate to adjust to the new target following an announcement.

Adjustments in the discount rate usually lag behind changes in the funds rate. Once the spread between the two rates gets too large (meaning fat profits for the big banks which routinely borrow from the Fed at the discount rate and lend to smaller banks at the funds rate) the Fed moves to adjust the discount rate accordingly. It usually happens when the spread reaches about 1%.

Another interest rate of significant interest is the Prime Rate, the interest that a bank charges its "best" customers. There is no single prime rate, but the commercial banks generally offer the same prime rate. The Fed does not adjust a bank's prime rate directly, but indirectly. The change in discount rates will affect the prime rate. As of April, 1997 the prime rate is 8.5%.

For an in-depth look at the Federal Reserve, get the book by William Greider titled Secrets of the temple: How the Federal Reserve runs the country.

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