A:

The most important interest rates in the economy are the Federal funds rate and the discount rate. The Federal funds rate is the overnight lending rate banks charge each other. This is also known as the prime rate, and all types of credit instruments, such as mortgage rates, bond yields, corporate debt and credit card debt, are priced based on this rate.

Small changes in the prime rate can have staggering effects on prices, sentiment, liquidity, the behavior of market participants and the direction of the economy. Even expectations of a change in the Federal funds rate have an impact on asset prices. Market participants parse incoming economic data and the words of central bank officials to gain a better understanding of the future direction of this rate.

The discount rate is the rate the Federal Reserve charges banks to borrow funds. This is one of the main tools the Federal Reserve has to control the money supply. If the Federal Reserve seeks to stimulate lending activity, it can lower this rate so lending is more profitable to banks. If it seeks to combat inflationary pressures and shrink the money supply, it can raise this interest rate, which decreases lending.
Both of these rates are important because they determine the money supply of the economy and pricing of other credit instruments. Through fiscal, banking and monetary channels, these rates end up influencing, and in some cases, determining factors as varied as credit growth; financial conditions; interest payments for government, corporations and individuals; consumer confidence; commodity markets; stock markets; bond markets; and employment.

RELATED FAQS
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  2. How does the Federal Reserve determine the discount rate?

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  3. What are the implications of a high Federal Funds Rate?

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  4. How does the Federal Reserve's set discount rate affect my personal finances?

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  5. When was the last time the Federal Reserve hiked interest rates?

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