The Federal Reserve (the Fed) sets overnight borrowing rates between banks in the United States by controlling the money supply. It has the dual mandate to control inflation and keep the economy robust. When the economy is booming, the Fed raises rates to keep it from overheating and causing inflation. When the economy is sluggish, the Fed will reduce rates in order to stimulate business activity.
Federal funds rate and discount rate
Federal funds rate This is the rate that the Fed sets for overnight lending between banks. The overnight lending keeps the system liquid. Federal discount rate When a bank needs money on a short-term basis, it can come directly to the Fed for a loan at the discount rate. This rate is usually a little higher than the funds rate, but it is still low, and it is designed to keep the system liquid even when banks are not lending to each other.
Changes in interest rates
When the Fed changes the Federal funds rate, it is an important event in financial circles, especially if it is not anticipated. In order to keep the markets calm, the Fed usually signals rate changes in advance. Current rates The current Fed funds rate is 0.25%; the current discount rate is 0.75%. As of this date, 7/20/11, there is expectation that the funds rate will not change in the next few months. The Fed has consistently used language that indicates they will keep the rates low for a long time. Other rates In the United States, the prime rate is normally about three percentage points above the funds rate, so currently the prime rate, the borrowing rate of the best borrowers is 3.25%. All consumer borrowing rates are based on the funds or prime rate, so changes in these are important for business and consumer interests. Future changes The Fed has said that rates will be low for "an extended period of time." However, US treasury rates at the longer end of the yield curve are signaling that investors believe inflation will begin to rise as the world economy picks up again because of the spending by governments. Sentiment is heavily on the side of betting that the Fed will raise rates within the next year or so, and central banks around the world have either begun to raise rates or indicate that they are considering doing so.