DEFINITION of Key Rate
The key rate is the specific interest rate that determines bank lending rates and the cost of credit for borrowers. The two key interest rates in the United States are the discount rate and the Federal Funds rate.
BREAKING DOWN Key Rate
When a large percentage of account holders decide to withdraw their funds from a bank, the bank may be faced with liquidity issues or insufficient funds. This means that not all clients may be able to withdraw their money when requested. To avoid this issue, the Federal Reserve maintains a fractional reserve banking system, which requires banks to keep a certain percentage of their deposits in cash. When a bank falls short of its required reserve, it may borrow from other banks or directly from the Federal Reserve for a very short period of time. The key rates at which the bank can borrow from other banks and from the Federal Reserve are the Federal Funds rate and the discount rate, respectively.
The Federal Funds Rate is the rate at which banks can charge each other on loans used to meet their reserve requirements. This rate governs the overnight lending of Federal Reserve funds made available to private-sector banks, credit unions, and other loan institutions. If a bank decides to borrow directly from the Federal Reserve, it is charged the discount rate. The Federal Reserve sets the discount rate which, in turn, impacts the Federal Funds rate. If the discount rate is increased, banks are reluctant to borrow given that the cost of borrowing has been set higher. In this situation, banks will build up reserves and borrow less money to individuals and businesses. On the other hand, if the Fed reduces the discount rate, the cost of borrowing will be cheaper for banks, leading them to lend more money out and to borrow more funds to meet their reserve requirements.
The key rates are one of the chief tools used by the Federal Reserve system to implement monetary policy. When the Fed wants to expand the money supply in the economy, it will typically lower the discount rate in order to decrease the cost of borrowing. When the Fed is in a contractionary phase, it will raise the rates to increase the cost of borrowing.
The Fed is able to control the money supply by adjusting the key rate, since the prime rate depends on the key rate. The prime rate is the benchmark rate offered by banks to consumers. As a general rule of thumb, the national prime rate is 3 percentage points above the Fed funds rate. If the Fed funds rate increases after the discount rate increases, banks will alter their prime rates to reflect this change. Therefore, the rates on consumer loans, such as the mortgage rates and credit card rates, will also increase. By increasing (or decreasing) the key rates, the cost of borrowing increases (or decreases), causing consumers to save more (spend more) and spend less (save less). This leads to an economy contraction (or expansion).