[eli5] Why is US federal interest rate highly important in the financial world?
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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.
The US Federal interest rate is very important because it’s considered the risk free rate of return. In general, investors expect to be compensated for taking additional risks compared to US bonds when investing with returns better than whatever the US Federal interest rate is.
The US Federal interest rate is very important because it’s considered the risk free rate of return. In general, investors expect to be compensated for taking additional risks compared to US bonds when investing with returns better than whatever the US Federal interest rate is.
The US Federal interest rate is very important because it’s considered the risk free rate of return. In general, investors expect to be compensated for taking additional risks compared to US bonds when investing with returns better than whatever the US Federal interest rate is.
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