Federal Funds Rate vs. LIBOR: Significance and Key Differences

Introduction

Interest rates play a pivotal role in shaping economic conditions and financial markets. Two crucial benchmarks that often influence borrowing costs and investment decisions are the federal funds rate and the London Interbank Offered Rate (LIBOR). Understanding these benchmark rates is important for businesses as they make investment decisions. 

In this blog, we will understand these rates, their significance, and the key differences between them. 

What is the Federal Funds Rate?

The Federal funds rate is the interest rate at which depository institutions (banks and credit unions) lend reserve balances to other depository institutions overnight on an uncollateralized basis. It is a key tool used by the Federal Reserve to control monetary policy and stabilize the economy.

Changes in the federal funds rate impact interbank lending rates in the U.S., influencing interest rates on various banking products like savings accounts, certificates of deposit, and money market accounts. Additionally, it affects the Wall Street Journal Prime Rate, influencing consumer products such as credit cards, home equity loans, auto loans, personal loans, and small business loans.

What is the London Interbank Offered Rate (LIBOR)?

LIBOR is the average interest rate at which major global banks borrow from one another in the London interbank market. It serves as a benchmark for short-term interest rates globally and is extensively used in various financial instruments, including loans, mortgages, and derivatives.

Historically, LIBOR was a globally influential benchmark rate, calculated by averaging responses from large banks on their borrowing costs. It includes various durations like one-month and three-month LIBOR. 

Federal Funds Rate vs. LIBOR

The Federal Funds Rate and LIBOR are both crucial interest rate benchmarks, but they serve distinct purposes. Fed funds rate is controlled by the Federal Reserve and influences overnight lending among banks, while LIBOR reflects the cost of borrowing between banks globally, impacting a broader range of financial products.

1. Geographic scope

Both the rate benchmarks operate in different geographic regions—while the fed funds rate is set in the U.S., LIBOR is determined in London. 

2. Interest determination method 

The fed funds rate is a target rate set by the Federal Reserve, achieved through overnight lending among financial institutions. Banks can also borrow from the Fed at a higher fixed rate known as the discount rate, set above the fed funds rate target. 

Conversely, the LIBOR rates are calculated based on the rates submitted by major global banks. These rates were not based on actual transactions but are rates that banks assumed they could pay if they had to borrow money from other banks on the interbank lending market. It is published by the Intercontinental Exchange (ICE). 

3. Scope

The federal funds rate is a key monetary policy tool used by the Federal Reserve to influence economic activity in the United States. On the other hand, LIBOR is a widely used global benchmark for various financial instruments, including derivatives, loans, and mortgages. Moreover, the federal funds rate is solely applicable to the U.S. dollar.

LIBOR covers multiple currencies, reflecting its international scope.

4. Timing

The federal funds rate can be adjusted during Federal Open Market Committee meetings, which occur periodically when there is a perceived need to impact U.S. monetary policy. In contrast, LIBOR fluctuates daily and is published around 11:45 a.m., London Time, reflecting current borrowing costs in the interbank market.

5. Interest type

The Federal Funds Rate, controlled by the Federal Reserve, governs overnight lending within the U.S., while LIBOR, set by London banks, influences global borrowing costs across financial products worldwide. Understanding these distinctions is crucial for financial decision-making and market navigation

With strict banking regulations coming into being after the 2008 financial crisis, there was a drastic reduction in interbank borrowing and trading, which impacted the reliability of LIBOR. In 2017, the Federal Reserve brought together an Alternative Reference Rate Committee, which selected the Secured Overnight Financing Rate (SOFR) as the new benchmark interest rate for all USD trades. On November 30, 2020, the Fed announced LIBOR’s retirement. June 30, 2023, marked the retirement of LIBOR with the cessation of all LIBOR rates and the selection of SOFR as the new USD benchmark rate

How are They Related to Prime Rate?

The prime rate is the interest rate that commercial banks charge their most creditworthy customers. It is often closely tied to the federal funds rate and LIBOR, serving as the basis for consumer loans such as mortgages and credit cards. Changes in the federal funds rate and LIBOR typically influence movements in the prime rate.

Most variable-rate bank loans don’t directly follow the federal funds rate but typically trend in the same direction. This alignment is due to their ties to key benchmark rates like the prime rate and LIBOR, which are closely influenced by changes in the federal funds rate.

The prime rate, offered to the least risky customers by commercial banks, is determined by averaging rates from 10 major U.S. banks polled by The Wall Street Journal daily. This rate adjusts when a significant majority of banks change their rates, usually remaining slightly above the federal funds rate and moving in tandem with it.

For example, if the federal funds rate is 1.5%, the prime rate might be around 4.5%. So, someone with average credit could pay around 10.5% on their credit card (prime plus six percentage points). When the Federal Open Market Committee lowers rates, borrowers typically see immediate reductions in their borrowing costs.

Conclusion

In conclusion, understanding the federal funds rate and LIBOR is essential for grasping how interest rates impact borrowing costs and economic conditions. While the federal funds rate is a tool for U.S. monetary policy, LIBOR serves as a global benchmark, affecting a wide array of financial products. Monitoring these rates and their relationship to the prime rate can provide valuable insights into market trends and opportunities for borrowers and investors alike.

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FAQs

1. What is the significance of LIBOR?

LIBOR is significant as a global benchmark interest rate used to determine borrowing costs for a wide range of financial products worldwide. It influences trillions of dollars in loans, derivatives, and contracts, serving as a reference point for financial markets and impacting global economic stability.

2. What is the significance of the Fed rate?

The Fed rate, officially known as the federal funds rate, is significant because it serves as the benchmark interest rate in the United States. Set by the Federal Reserve, it influences borrowing costs for banks, businesses, and consumers, impacting economic activity, inflation, and employment levels nationwide.

3. What is the time frame of LIBOR?

LIBOR is typically quoted for several different durations, ranging from overnight to one year. The most commonly used durations include overnight, one week, one month, three months, six months, and one year. These reflect the varying borrowing periods in the interbank market for different financial products and contracts.

4. What is the time frame of the Fed rate?

The federal funds rate pertains to overnight lending between banks. It is set by the Federal Reserve’s Federal Open Market Committee (FOMC) during its meetings, typically eight times a year, to influence economic conditions and achieve monetary policy goals such as controlling inflation and promoting full employment.