Types of Interest Rates #primers

When we say that the Fed is “hiking rates”, this actually represents a variety of different interest rates of the short term funding market.

First, an important distinction. All these different rates effectively represent short term loans on cash and the interest rate associated with it. They can be generally categorized as unsecured (no collateral is pledged for the loan) vs secured (the loan is collateralized, usually with Treasury securities).

The Effective Federal Funds Rate (EFFR) is the rate of which unsecured lending occurs overnight between two banks. The FOMC commits to a range that it wants the EFFR to reside within. This is an unsecured loan which means the loan is transacted based on the implied trust between the two depository institutions alone. This makes for a more efficient market but can also lead to a potentially catastrophic daisy chain of unsecured loans with no backing.

Interest on Reserves (IOR) represents the overnight rate paid on bank reserves. It is the key rate that the Fed can directly set, allowing them to guide the target range for the FFR. Banks decide what to do with their excess reserves: either lend it to other banks at the FFR or deposit it at the Fed and earn the IOR rate. If the IOR rate is higher than the EFFR, more flows will go towards the higher rate. In practice, this IOR rate, along with the RRP rate, sets the floor of the Federal Funds Rate target range as it is the lowest rate offered that makes sense.

In addition, the overnight reverse repo rate (RRP rate) is the rate the Fed pays on reverse repo operations where both commercial banks and money market funds swap cash for short term (usually overnight) treasuries borrowed directly from the Federal Reserve at a certain rate.

The rate offered at the Discount Window (discount rate), which represents the rate commercial banks can use to borrow directly from the Fed and is typically only used in times of liquidity stress, acts as the ceiling to the FFR range.

#primers