We talk here and you’ve read elsewhere about what the Fed will or won’t do at their next round of FOMC meetings. The next round is the 15th and 16th of this month and most analysts agree and the Fed has all but telegraphed there will be a rate increase at the conclusion of these meetings, probably 0.25%. But what rate does the Fed adjust and why? The Fed directly and indirectly affects the cost of money borrowed, be it from an individual getting a mortgage or a car loan or a business seeking expansion capital. Currently, the Federal Funds rate, is at 0.25%. The other rate that is affected when the Federal Funds rate is changed is the Discount Rate.

The Fed Funds rate is the rate of interest that banks lend through the Federal Reserve to other banks. These loans are very short term, as in overnight. Why do banks make and receive such short term loans? Banks are required to keep a specific amount of reserves compared to the amount of loans outstanding. If a bank makes loans one day, the reserve is depleted and must be restored. This reserve is in the form of cash in the vault or deposits. If the bank finds the reserve will fall below the minimum required, the bank then borrows from another depository institution who will issue the short term funds at the rate specified by the Fed. That rate today is 0.25% but next week that same rate might be 0.50% after a rate increase. The other rate that is affected is the Discount Rate, which is established for much the same purpose but the loan comes directly from the Federal Reserve. The discount rate today is 0.75% but will follow lockstep to the Fed Funds rate increase so we can expect the discount rate to go to 1.00%.

The ability to adjust the cost of funds, in theory anyway, is meant to control the cost of money borrowed to stimulate a sluggish economy or to slow down a potentially overheated one, avoiding inflation. Apparently this thought doesn’t always work out as the Fed Funds rate has been so low for so long without any noticeable resurgence in the economy. Still, over time, adjusting these very basic rates does affect bank behavior and lending practices.