Fed Funds Rate vs. Prime Rate

Q.  As a frequent reader of your newsletter, you usually do a very good job of explaining things, but I still don’t understand what the Fed Funds Rate is that you sometimes refer to and how it relates to the Prime Rate.  Please explain.

A. In brief, the “Federal Funds Rate” is the interest rate at which banks (depository institutions) lend balances (federal funds) via the Federal Reserve to other banks (depository institutions) overnight.  Example:  Bank of America could lend $50 million to Wells Fargo overnight at 5.25%.

The Prime Rate, on the other hand, is the lowest commercial interest rate that banks will make on the short-term loans to their most creditworthy borrowers.  It is 3% above the Fed Funds Rate. Example: Bank of America (again) could loan Chevron Oil (a commercial enterprise, not a depository institution) $50 million at 8.25% for 270 days (short-term time frame, but longer than overnight).

In longer form, here’s the “mechanics” of the system.

U.S. banks and thrift institutions are obliged by law to keep certain non-interest-bearing reserves with the Fed (or to keep an equal amount of vault cash, but this imposes risks and costs). The level of these reserves is determined by the outstanding assets and liabilities of each depository institution, as well as by the Fed itself, but is typically 10% of the total value of the bank's demand accounts.

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