Key Rate: Definition, Types, and Importance

Key takeaways
* The key rate determines how much banks pay to borrow short-term funds and strongly influences consumer credit costs.
* Two primary key rates in the U.S. are the federal funds rate (interbank overnight lending) and the discount rate (borrowing from the Federal Reserve).
* Changes in key rates affect the prime rate, consumer loan rates, saving and spending behavior, and overall economic expansion or contraction.

What is the key rate?

The key rate is the short-term interest rate that governs how banks obtain funds when they need to meet reserve requirements or cover shortfalls. It directly affects how expensive it is for banks to borrow and, through that channel, the cost of credit for businesses and consumers.

Fractional-reserve banking
* Banks hold only a fraction of deposits as cash reserves. When reserves run low, banks borrow to meet regulatory or liquidity needs.
* They can borrow overnight from other banks at the federal funds rate or borrow directly from the Federal Reserve at the discount rate.

Types of key rates

• Federal funds rate: The rate banks charge one another for overnight loans to meet reserve requirements. It is a central benchmark for short-term interest rates in the economy.
• Discount rate: The interest rate the Federal Reserve charges banks that borrow directly from the Fed’s discount window. It is typically set above the effective federal funds rate and serves as a backstop source of liquidity.

How the Federal Reserve uses key rates

The Federal Reserve influences the economy by adjusting these key rates and conducting open-market operations:
* To expand the money supply and stimulate the economy, the Fed lowers target rates and purchases securities, making borrowing cheaper.
* To contract the money supply and cool an overheated economy, the Fed raises rates and sells securities, making borrowing more expensive.

Relationship to consumer rates

• The prime rate — the benchmark rate banks use to price many consumer loans — generally moves with the federal funds rate (commonly several percentage points higher than the fed funds rate).
• When key rates rise, consumer borrowing costs (mortgages, credit cards, business loans) usually increase, which tends to reduce spending and slow economic growth.
• When key rates fall, borrowing becomes cheaper, typically encouraging spending and investment.

Practical implications

• Large withdrawals: Because banks maintain limited cash reserves, very large or simultaneous withdrawals can create temporary liquidity constraints. This is a normal feature of fractional-reserve banking.
• For borrowers and savers: Watch key rate movements to anticipate changes in loan rates, mortgage costs, and savings yields. Central bank statements and the federal funds target range are primary signals.

Conclusion

Key rates are fundamental levers of monetary policy. By setting or guiding short-term borrowing costs, the Federal Reserve influences bank behavior, the prime rate, consumer borrowing, and overall economic activity. Understanding how federal funds and discount rates work helps interpret interest-rate shifts and their effects on financial markets and everyday borrowers.