[eli5] Why is US federal interest rate highly important in the financial world?
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The US federal interest rate is highly important in the financial world because it serves as a benchmark for many other interest rates in the economy. When the Federal Reserve, which is the central bank of the United States, sets its target interest rate, it influences the interest rates that banks charge each other for loans, as well as the interest rates that consumers and businesses pay for various types of loans, such as mortgages, car loans, and credit cards. Additionally, changes in the federal interest rate can have a ripple effect on other aspects of the economy, such as inflation and employment levels. As a result, the federal interest rate is closely watched by investors, economists, and policymakers around the world, as it can signal important shifts in the global financial landscape.
The US federal interest rate is highly important in the financial world because it serves as a benchmark for many other interest rates in the economy. When the Federal Reserve, which is the central bank of the United States, sets its target interest rate, it influences the interest rates that banks charge each other for loans, as well as the interest rates that consumers and businesses pay for various types of loans, such as mortgages, car loans, and credit cards. Additionally, changes in the federal interest rate can have a ripple effect on other aspects of the economy, such as inflation and employment levels. As a result, the federal interest rate is closely watched by investors, economists, and policymakers around the world, as it can signal important shifts in the global financial landscape.
It affects the interest rate of all other debt in USD. A lot of debt is in USD, even outside the USA
It affects the interest rate of all other debt in USD. A lot of debt is in USD, even outside the USA
It affects the interest rate of all other debt in USD. A lot of debt is in USD, even outside the USA
other comments are saying “this is the rate at which banks borrow from the government”. this statement is true but further clarity may be needed. when we say this, banks are not taking out loans from the government in the same way that a consumer takes out a 30 year mortgage.
banks are constantly dealing with very short term funding mechanics on a daily basis, and they have trading desks dedicated to trading with the federal reserve’s trading desk daily in order to manage the bank’s treasury in what is virtually real time when compared against a long term loan. this daily dealing is where the “federal interest rate”, technically known as the federal discount rate, comes in.
that is also why you may hear the big banks referred to as “federal reserve member banks”. there is a specific group of banks (all the big national household names) that are approved to deal directly with the federal reserve in this way.
other comments are saying “this is the rate at which banks borrow from the government”. this statement is true but further clarity may be needed. when we say this, banks are not taking out loans from the government in the same way that a consumer takes out a 30 year mortgage.
banks are constantly dealing with very short term funding mechanics on a daily basis, and they have trading desks dedicated to trading with the federal reserve’s trading desk daily in order to manage the bank’s treasury in what is virtually real time when compared against a long term loan. this daily dealing is where the “federal interest rate”, technically known as the federal discount rate, comes in.
that is also why you may hear the big banks referred to as “federal reserve member banks”. there is a specific group of banks (all the big national household names) that are approved to deal directly with the federal reserve in this way.
other comments are saying “this is the rate at which banks borrow from the government”. this statement is true but further clarity may be needed. when we say this, banks are not taking out loans from the government in the same way that a consumer takes out a 30 year mortgage.
banks are constantly dealing with very short term funding mechanics on a daily basis, and they have trading desks dedicated to trading with the federal reserve’s trading desk daily in order to manage the bank’s treasury in what is virtually real time when compared against a long term loan. this daily dealing is where the “federal interest rate”, technically known as the federal discount rate, comes in.
that is also why you may hear the big banks referred to as “federal reserve member banks”. there is a specific group of banks (all the big national household names) that are approved to deal directly with the federal reserve in this way.
FYI, you’re getting two different kinds of answers because there are two ways to interpret “federal interest rate.”
One is the interest rate that the federal government pays to borrows money. That is important in finance because it’s considered the “risk free rate.” When the bank checks your credit before giving you a loan, they are trying to figure out what is the probability that you’ll fail to pay it back. The greater that probability, the greater the interest rate they will charge you. The probability of US federal government being unable to pay its debt (in the short term) is considered essentially 0%. Therefore the rate they pay is the lowest possible (today it’s around 3.5% for a 10-year bond). Therefore, if you go to buy a house or a car, the bank will calculate your interest rate starting with 3.5% and then add a premium on top of that depending on how risky they think you are (plus other factors). Basically 3.5% becomes the minimum for all loans in the US and to a large degree in the world.
The other way to interpret your question is the Federal Reserve Bank’s (not the government) overnight lending rate. This is the rate makes a lot of headlines. Banks are required to keep a certain percentage of their customers’ money “in reserve” in their account at the Fed Bank (the bank of banks). If a given bank falls below that level, they borrow money from another bank that has a little extra in their reserve, usually in the form of a 1-day loan. The interest rate banks charge each other when they do this is the Fed Funds Rate. (Note, none of this includes anyone borrowing money from the government, those answers are wrong.). Currently the rate is at 5%. This, again, acts as a minimum rate for you and me, because your bank has the choice to either lend money to you or they could lend it to another bank. If they could make more money lending it to another bank, then they would do that. In order for you to be a worthwhile investment, you have to pay some rate higher than the fed rate.
Both of these things combined are the reason why you can’t get a home loan for less than 7% today no matter how good your credit is.
FYI, you’re getting two different kinds of answers because there are two ways to interpret “federal interest rate.”
One is the interest rate that the federal government pays to borrows money. That is important in finance because it’s considered the “risk free rate.” When the bank checks your credit before giving you a loan, they are trying to figure out what is the probability that you’ll fail to pay it back. The greater that probability, the greater the interest rate they will charge you. The probability of US federal government being unable to pay its debt (in the short term) is considered essentially 0%. Therefore the rate they pay is the lowest possible (today it’s around 3.5% for a 10-year bond). Therefore, if you go to buy a house or a car, the bank will calculate your interest rate starting with 3.5% and then add a premium on top of that depending on how risky they think you are (plus other factors). Basically 3.5% becomes the minimum for all loans in the US and to a large degree in the world.
The other way to interpret your question is the Federal Reserve Bank’s (not the government) overnight lending rate. This is the rate makes a lot of headlines. Banks are required to keep a certain percentage of their customers’ money “in reserve” in their account at the Fed Bank (the bank of banks). If a given bank falls below that level, they borrow money from another bank that has a little extra in their reserve, usually in the form of a 1-day loan. The interest rate banks charge each other when they do this is the Fed Funds Rate. (Note, none of this includes anyone borrowing money from the government, those answers are wrong.). Currently the rate is at 5%. This, again, acts as a minimum rate for you and me, because your bank has the choice to either lend money to you or they could lend it to another bank. If they could make more money lending it to another bank, then they would do that. In order for you to be a worthwhile investment, you have to pay some rate higher than the fed rate.
Both of these things combined are the reason why you can’t get a home loan for less than 7% today no matter how good your credit is.
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