What is a Key Rate?
A bank or other institution uses the key rate to determine the interest rate on debt. In the United States, there are two key rates: the discount rate and the Fed Funds rate.
How Does a Key Rate Work?
To understand key rates, it is important to understand that banks derive income from making loans. When lending generates profit for banks, they are motivated to lend as much of their deposits as possible. This is a problem when a large number of depositors suddenly want to withdraw their money. To prevent the panic that would naturally occur in this situation, the Federal Reserve maintains a fractional reserve banking system, which requires banks to keep a certain percentage of their deposits in cash.
The Federal Reserve Discount Rate
When a bank is unable to meet the reserve requirement, it can borrow those funds from another bank or directly from the Federal Reserve. If it borrows from another bank, it can get a Federal Funds loan; borrowing from the Federal Reserve involves borrowing from the Fed's 'Discount Window' at the Discount Rate. The loans are unsecured and are for very short periods (typically overnight).
The Fed Funds Rate
The Federal Funds Rate is the interest rate banks charge each other on loans used to meet reserve requirements. The Federal Funds Rate is often confused with the Discount Rate.
When a bank is unable to meet the reserve requirement, it can get a Fed Funds loan. Federal Funds loans are usually made through brokers who specialize in such transactions, or they are made directly between the banks themselves.
Why Does a Key Rate Matter?
The Federal Reserve sets the discount rate, and by doing so it influences the Federal Funds Rate, which is the rate at which banks borrow from each other. An increase in the discount rate discourages banks from borrowing to meet reserve requirements, causing them to build up reserves (and thus lend out less money). A reduction in the discount rate has the opposite effect: it encourages banks to borrow to meet reserve requirements, which makes more money available for lending.
Accordingly, the Federal Reserve can trigger a change in the Federal Funds rate by changing the discount rate. This is why the discount rate and the Federal Funds rate are closely correlated key rates.