Money Market Rates and the Federal Reserve
How money market rates interact with the federal reserve is an the intricate process. The Federal Reserve Rate, also commonly referred to as the Federal Fund Rate, is what one bank charges another bank when they lend money overnight from their reserve funds. Federal law says that banks must have a reserve that is equal to a certain percentage of the balance in all of their deposit accounts. Any money in their reserve that is more than this percentage is available for lending to other institutions. If banks have less than this percentage in their reserve, then they are at risk of a ‘shortfall’ and are able to borrow from other institutions’ reserves at the Federal Reserve Rate to meet this minimum reserve requirement.
You’re probably thinking “What the heck did I just read?”. Simply put, the U.S. government wants to be sure that banks have security in the extremely rare event that a bunch of people decide to all go to the bank on the same day and withdraw everything from their checking and savings accounts. There are other rules in place as well, like limiting the number of withdrawals on a U.S.-based savings account. Because money market accounts are considered ‘savings deposit accounts’ by the feds, they are subject to this withdrawal limit as well.
But how does the federal reserve rate affect money market interest rates? How does it affect interest rates on other products and services, like other types savings accounts? Well, I’m glad you’ve asked!
Banks Make Money From Lending
Banks and financial institutions turn a huge profit from lending money. Whether they’re lending this money out to individuals, businesses, or other banks, it doesn’t matter because money is money. Whose money is the bank loaning out? Yours, of course! Banks take their depositors’ money, lend it out to other people and institutions, and profit from the interest they collect on repayments. One reason for the reserve rule mentioned earlier in the article is to prevent banks from simply loaning out every dollar that their institution holds.
Contrary to what some may believe, banks don’t exactly keep their doors open by charging NSF fees and late fees, though those do account for a nice chunk of change. The primary principle behind a successful bank is to collect more in interest payments from lending than they pay out in interest on products like money market accounts.
Open An Account, I’ll Pay You!
Because banks loan out money stored at their institution, they need to entice people to open accounts and keep their money with them. And because people are more likely to leave their money alone if it is accruing interest, they want to pay you to keep your money at their institution. If you want an interest-bearing account then you’re likely going to go for a money market account or some type of savings account. More and more institutions are also offering interest-based checking accounts as well. The interest paid to you on your deposit accounts comes from what the bank made while they were out there lending money. They’re essentially tossing you some form of commission from letting them use your money.
Behind The Scenes of Money Market Accounts
The more money that a bank collects in interest payments from their lending practices, the more they’re able to pay you for keeping your money with them. Although it’s becoming more and more common, interest-bearing checking accounts are not yet an industry standard. Savings accounts pay interest, but you can’t really use a debit card or write a check and have the funds come from your savings account. Money market accounts are a hybrid, of sorts, of a checking account and a savings account. (Money Market Accounts are subject to Regulation D!)
Money market accounts typically have higher-than-savings interest rates. You get the flexibility of a checking account (within reason), with typically higher interest rates than savings accounts. But how and why do banks pay more for money market accounts than a regular savings account?
Banks are very limited to how they lend funds from their depositors’ savings account balances. A money market account gives banks more flexibility with how they lend and invest the money. With depositor money market funds, banks are able to still lend to other institutions as mentioned above, but they are also able to make low-risk investments in things like government bonds and certificates of deposit (CDs).
Money Market Interest Rates
The federal reserve rate is historically the number-one factor when it comes to predicting economic stability for the future, so you can see just how influential it is. Because of its influence on local markets and economies, banks will often base interest rates for their other lending products on this federal reserve rate. A bank may offer a line of credit with a variable rate of FRR + 4% – meaning, whatever the federal reserve rate is plus 4%.
Banks have to keep their interest rates competitive in order to stay in business and be as profitable as possible for their investors. This means offering low interest rates when lending to people and institutions, while still trying to pay competitive interest rates on deposit accounts. The more a bank can profit off of its lending practices, the more they are able to pay depositors on their money market and savings accounts.
Simply Put: If the federal reserve rate goes up, then banks will be earning more profit from the higher interest rates on the money they lend out. Because of the increased profit from higher interest rates, they can pay you more interest on your deposit accounts. Alternatively, if the federal reserve rate goes down, you will likely earn less on your money market and deposit accounts.