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How Central Banks Affect Interest Rates

The central bank of the United States—the Federal Reserve (the Fed)—is tasked with maintaining a certain level of stability within the country’s financial system.

 

Overnight Lending and Bank Reserves

Banks are required by the Fed to have a minimum amount of reserves on hand, which is currently set at 0% in response to the 2020 crisis.  This meant that a bank with $1 million on deposit had to maintain at least $100,000 on reserve and was free to lend out the remaining $900,000 to borrowers or other banks.

It would then have had to borrow the other $50,000 overnight as a short-term loan.

It would prefer to lend those excess reserves and earn a small amount of income on it rather than have it sit idly as cash earning zero yield. The rate at which banks lend to each other overnight is called the federal funds rate (or fed funds rate for short), and is set by the supply and demand in the market for such short-term reserves loans.

If there are no banks with reserves willing to lend to those in need, that bank can instead borrow directly from the Fed, at a rate known as the discount rate.

The Fed Funds Rate and Discount Rate

For banks and depositories, the discount rate is the interest rate assessed on short-term loans acquired from regional central banks. In other words, the discount rate is the interest rate at which banks can borrow from the Fed directly.

Financing received through federal lending is most commonly used to shore up short-term liquidity needs for the borrowing financial institution;

Remember, the interest rate on the inter-bank overnight borrowing of reserves is called the “fed funds rate.” It adjusts to balance the supply of and demand for reserves.  The Fed offers discount rates for three different types of credit: primary credit, secondary credit, and seasonal credit. These discount rates are currently 0.25%, 0.75%, and 0.15% respectively.2

As a result, in most circumstances, the amount of discount lending under the discount window facility is very small.

Decreasing Interest Rates

When the Fed makes a change to either the fed funds rate or the discount rate, economic activity either increases or decreases depending on the intended outcome of the change.

This creates an economic environment that encourages consumer borrowing and ultimately leads to an increase in consumer spending while rates are low.

This may discourage long-term savings in safe investment options such as certificates of deposit (CDs) or money market savings accounts.

Increasing Interest Rates

When the economy is growing at a rate that may lead to hyperinflation, the Fed may increase interest rates.

The Bottom Line

The Fed, like all central banks, uses interest rates to manage the macroeconomy. Raising rates makes borrowing more expensive and slows down economic growth while cutting rates encourage borrowing and investment in cheaper credit.

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