Federal Funds, Prime, and Discount Interest Rates

Three well-known interest rates are the federal funds rate, the prime rate, and the discount rate. These are often confused so let’s define them clearly.

The federal funds rate is the interest rate on overnight, interbank loans. In other words, banks with excess reserves lend to other banks (i.e. interbank) who need reserves to meet their reserve requirement. These loans are typically for 24 hours (i.e. overnight). The federal funds rate is possibly the best indicator of credit conditions on short term loans, and changes in credit conditions are quickly reflected by changes in the federal funds rate.

The prime rate is the interest rate banks charge their very best corporate customers, borrowers with the strongest credit ratings. If Google were to borrow money from Bank of America for a short period of time, Google would be charged Bank of America’s Prime Rate. Customers with less strong credit ratings would be charged more than the prime rate (typically thought of as Prime rate plus a premium). The prime rate is thus the floor on which a bank’s short term rates of different types are based. Additionally, variable interest rates like car loans or credit cards are often based on the prime rate. When the prime rate changes, variable interest rates will change also. Since each bank can charge its own prime rate, the published prime rate is the consensus or average rate banks charge. Both the federal funds rate and the prime rate are market determined interest rates. In other words, they are determined through the interaction between supply and demand in their respective credit markets.

The discount rate, by contrast, is the interest rate charged by the Federal Reserve for discount loans. As such, it is not market determined, but rather set by the Federal Reserve. We will discuss these interest rates in more detail in future modules.

Self Check: Federal Funds, Prime and Discount Interest Rates

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