Federal Funds Rate vs. LIBOR: An Overview
In macroeconomics, the interest rate plays a crucial role in delivering an equilibrium on the assets market by equating the demand and supply of funds. The two most prominent interest rates widely featured are the federal funds rate and the London Interbank Offered Rate (LIBOR).
The federal funds rate is mostly relevant for the U.S. economy, as it represents the rate at which highly creditworthy U.S. financial institutions trade balances held at the Federal Reserve, usually overnight. The federal funds rate is set by the U.S. Federal Reserve. LIBOR represents a benchmark rate that leading global banks charge each other for short-term loans. Unlike the federal funds rate, LIBOR is determined by the equilibrium between supply and demand on the funds market, and it is calculated for five currencies and different periods ranging from one day to one year.
- Benchmark interest rates are essential for setting interest rates on all sorts of debts from corporate bonds to mortgages to the rate that banks lend to each other.
- The federal funds rate is established by a market mechanism for overnight lending on reserves, and a target is set by the FOMC.
- LIBOR has several maturities, with the interest rate set in London through a syndicate of financial institutions.
Federal Funds Rate
The federal funds rate (fed funds rate) is one of the most important interest rates for the U.S. economy, as it affects broad economic conditions in the country, including inflation, growth, and employment. The Federal Open Market Committee (FOMC) sets the target for the federal funds rate and achieves the preset rate through open market operations. The federal funds rate is set in U.S. dollars and is typically charged on overnight loans. The fed funds rate is the interest rate at which commercial banks lend reserves to one another on an overnight basis.
London Interbank Offered Rate
LIBOR is an important rate used worldwide by financial institutions to determine the interest rate to be charged on various loans. LIBOR is based on five currencies: the U.S. dollar, euro, pound sterling, Japanese yen, and Swiss franc. There are typically seven maturities for which LIBOR is quoted: overnight, one week, and one, two, three, six, and 12 months. The most popular LIBOR rate is a three-month rate based on the U.S. dollar.
Several differences exist between LIBOR and the fed funds rate. First is geography—the fed funds rate is set in the U.S., while LIBOR in London. That doesn't mean that loans or other debts issued in the United States do not use LIBOR as their benchmark. In fact many do, such as mortgage rates which are set to "prime"—or LIBOR plus some mark up.
The fed funds rate, while given as a target by the Federal Reserve, is actually achieved in the market for overnight lending amongst financial institutions. The Fed does establish a fixed rate, known as the discount rate, which is the interest rate that the Fed will lend to banks through the so-called discount window. The discount rate is always set higher than the federal funds rate target, and so banks would prefer to borrow from one another rather than pay higher interest to the Fed. However, if the demand for reserves is sufficient, then the fed funds rate will tick up. LIBOR, on the other hand, is set by a syndicate of investment houses in London each day without a market mechanism.
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.
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 with the federal funds rate.
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 federal 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 federal 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.