If you watch the news, you undoubtedly hear from time to time that the Federal Reserve has decided to increase or decrease its key interest rate. When this is the case, you can probably guess that the central bank is trying to either slow economic growth or give the country a financial lift.

Perhaps less clear is whether a change to this interest rate, known as the federal funds rate, impacts you on a personal level. If you have a credit card, an adjustable-rate mortgage or a private student loan, it probably does. Many variable-rate financial products are tied to either of two benchmark rates – prime or LIBOR. And while the Fed doesn’t control these rates directly, they do tend to move in the same direction as the federal funds rate.

An Overview of the Funds Rate

To understand how decision-making by the Fed – and more specifically, its Federal Open Market Committee – affects consumer and business loans, it’s important to understand how the federal funds rate works.

According to U.S. regulations, lending institutions have to hold a percentage of their deposits with the Federal Reserve every night. Requiring a minimal level of reserves helps stabilize the financial sector by preventing a run on banks during times of economic distress. What happens when a U.S. bank is short on cash at a given time? It has to borrow it from other lenders. The funds rate is simply the rate one bank charges another institution for these unsecured, short-term loans.

So how does the Fed influence this rate, exactly? It has two main mechanisms it can use to achieve the target rate desired: buying and selling government securities in the open market, and changing the required reserve percentage.

When the Fed buys or sells government securities in the open market, it adds or reduces the amount of cash in circulation. This way, the Fed is able to dictate the price of borrowing among commercial banks. Let’s say the committee agrees that the economy needs a boost and decides to reduce its target rate by a quarter of a percentage point. To do this, it buys a specific amount of government securities on the open market, infusing the financial system with cash. According to the laws of supply and demand, this influx of cash means private banks aren’t able to charge each other as much for loans. Therefore, the rate for overnight lending among commercial banks goes down. If the Fed wants to increase the rate, it could do the opposite by going into the open market and selling government securities. This reduces the amount of cash in the financial system and influences banks to charge each other a higher rate.

Changing the required reserve percentage has a similar effect but is seldom used. Reducing the required reserve percentage increases excess reserves and cash in the system. The opposite is true when increasing the required reserve percentage. The reason it is not a very common approach by the Fed is that it is considered the most powerful tool for influencing economic growth. Given the magnitude of the U.S. financial system, its movements are felt worldwide, and a minimal change in the required reserve percentage could have a bigger impact than desired.

Relationship to Prime

While most variable-rate bank loans aren’t directly tied to the federal funds rate, they usually move in the same direction. That’s because the prime and LIBOR rate, two important benchmark rates to which these loans are often pegged, have a close relationship to federal funds.

In the case of the prime rate, the link is particularly close. Prime is usually considered the rate that a commercial bank offers to its least-risky customers. The Wall Street Journal asks 10 major banks in the U.S. what they charge their most creditworthy corporate customers. It publishes the average on a daily basis, although it only changes the rate when 70% of the respondents adjust their rate.

While each bank sets its own prime rate, the average consistently hovers at three percentage points above the funds rate. Consequently, the two figures move in virtual lock-step with one another.

If you’re an individual with average credit, your credit card may charge prime plus, say, six percentage points. If the funds rate is at 1.5%, that means prime is probably at 4.5%. So our hypothetical customer is paying 10.5% on his/her revolving credit line. If the Federal Open Market Committee lowers the rate, he/she will enjoy lower borrowing costs almost immediately.

The LIBOR Connection

While most small and mid-sized banks borrow federal funds to meet their reserve requirements – or lend their excess cash – the central bank isn’t the only place they can go for competitively priced short-term loans. They can also trade eurodollars, which are U.S.-dollar denominated deposits at foreign banks. Because of the size of their transactions, many larger banks are willing to go overseas if it means a slightly better rate.

LIBOR, perhaps the most influential benchmark rate in the world, is the amount banks charge each other for eurodollars on the London interbank market. The IntercontinentalExchange (ICE) group asks several large banks how much it would cost them to borrow from another lending institution every day. The filtered average of the responses represents LIBOR. Eurodollars come in various durations, so there are actually multiple benchmark rates - one-month LIBOR, three-month LIBOR and so on.

Because eurodollars are a substitute for federal funds, LIBOR tends to track the Fed’s key interest rate rather closely. However, unlike the prime rate, there were significant divergences between the two during the financial crisis of 2007-2009.

Figure 1

The following chart shows the funds rate, prime rate and one-month LIBOR over a 10-year period. The financial upheaval of 2008 led to an unusual divergence between LIBOR and the funds rate.

Fed Funds data

(Data from the Federal Reserve Bank of St. Louis)

Part of this has to do with the international nature of LIBOR. Many foreign banks around the world hold eurodollars, too. As the crisis unfolded, many hesitated to lend or feared that other banks wouldn’t be able to pay back their obligations. Meanwhile, the Federal Reserve was busy buying securities in an effort to bring down the funds rate for domestic lenders. The result was a significant split between the two rates before they once again converged.

If you happened to have a loan indexed to LIBOR, the effect was sizable. For instance, a homeowner with an adjustable-rate mortgage that reset during late 2008 may have seen his/her effective interest rate jump more than a full percentage point overnight.

The Bottom Line

Two of the most prominent benchmark rates, prime and LIBOR, both tend to track the federal funds rate closely over time. However, during periods of economic turmoil, LIBOR appears more likely to diverge from the central bank’s key rate to a greater extent. For those with a LIBOR-pegged loan, the consequences can be significant.

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