Ever wonder how the economy goes ’round? Or how inflation is controlled, and recessions are avoided? A lot has to do with the Fed and its tight control of key interest rates. These different interest rates do different things, but how does it trickle down to us?
Discount Rate: The Discount Rate is the interest rate the Fed offers to member banks and thrifts who need to avoid having their reserves dip below the required minimum. The higher the discount rate, the higher mortgage interest rates will be. When the discount rate goes up, the prime rate goes up as well, which slows the demand for new loans, and cools the housing market. Our credit card rates are typically tied to the Discount; this is the stuff seniors rely on for retirement. It’s a double edged sword. Lower Discount rates lower CD rates.
The opposite is also true. If the fed lowers the discount rate, the prime rate will come down, and mortgage interest rates will dip to more favorable levels. This can boost a slumping housing market.
So when we hear the Fed is cutting the Discount rate, it’s very possible that mortgage rate will decrease.
Prime Rate: Prime Rate is the interest rate offered by commercial banks to its most valued corporate customers. The prime rate is also the basis for many mortgage programs, including Heloc’s (Home Equity Lines of Credit,) which many banks offer to homeowners at prime plus X amount, prime minus X amount, or simply prime plus zero.
The prime rate always adjusts according to how the Fed changes the discount rate. So if the Fed lowers the Discount rate, it really does not affect this market.
Federal Funds Rate: The Federal Funds Rate is what banks charge one another for overnight use of excess reserves. Banks avoid dipping below their required percentage of money on reserve by borrowing from one another.
The Fed uses the federal funds rate to control the supply of available funds, essentially controlling inflation. If the federal funds rate is low, banks will be keen to borrow from one another, using the reserves to grant more loans which in turn feeds the economy. If the Fed feels the needs to slow things down, they will simply raise the federal funds rate, which will curtail borrowing among banks and reduce the amount of new loans,
My friend Fed Fund Rate does not mean Jack to you and me! It’s pretty much the good old boys, taking care of each other.