Key Rate: Definition, Types, and Importance

What Is the 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 U.S. are the discount rate and the federal funds rate. These are rates that are set, either directly or indirectly, by the Federal Reserve, in order to influence lending and the supply of money and credit in the economy.

Key Takeaways

  • The key rate determines the lending rates for banks as well as the cost of credit for borrowers. 
  • The two types of key rates are the discount rate and the federal funds rate. 
  • The key rate will determine the rate at which banks can borrow in order to maintain their reserve levels. 
  • The Federal Reserve can influence the rate at which banks can borrow money in order to expand or contract the national economy. 

Understanding the Key Rate

The key rate is the interest rate at which banks can borrow when they fall short of their required reserves. They may borrow from other banks or directly from the Federal Reserve for a very short period of time. The rate that banks can borrow from other banks at is called the federal funds rate. The rate banks borrow from the Federal Reserve at is called the discount 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 because the bank does not have the money it owes them. This occurs because, the Federal Reserve maintains a fractional reserve banking system, which requires banks to keep only a small percentage of their deposits in cash—also known as the reserve requirement. 

When storing large amounts of money in any bank, it is important to remember that their available reserves at any given time may influence the amount of cash that you can withdraw at once.

Special Considerations 

Key rates are one of the chief tools used by the Federal Reserve System to implement monetary policy. When the Federal Reserve wants to expand the money supply in the economy, it will typically buy bonds on the open market with newly created money using the federal funds' rater to gauge the volume and speed of bond purchased needed. When the Federal Reserve is in a contractionary phase, it will raise the rates to increase the cost of borrowing.

The Federal Reserve 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 usually about 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. 

When key rates increase, the cost of consumer borrowing increases, causing consumers to save more and spend less, therefore causing the economy to contract. Lowering key rates will lower the cost of borrowing and cause a decrease in saving and an increase in spending—expanding the economy. 

Types of Key Rates

The fed funds rate is the rate that banks charge each other on loans used to meet their reserve requirements. This rate governs the overnight lending of 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. 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 lend 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.