What is the Federal Funds Rate and How Does it Impact Loan Rates? You've probably heard the term federal funds rate mentioned on the news or by a relative interested in the economy, but what does it mean? The federal funds rate is...

You've probably heard the term federal funds rate mentioned on the news or by a relative interested in the economy, but what does it mean? The federal funds rate is the interest rate banks charge each other for borrowing short-term money. The Federal Reserve sets the rate which affects inflation, economic growth, loan, and savings rates. Let's dive deeper into how the rate is determined and its economic impact.

Key takeaways

• The federal funds market developed leading up to the Great Depression as the Fed learned to use monetary policy to achieve macroeconomic stabilization goals.
• The Federal Reserve sets a target rate to keep inflation in check and keep banks liquid.
• While the direction of the rate can often be controversial, the Federal Reserve uses various reports to decide what the rate should be.

What is the Federal Funds Rate?

The federal funds rate is the interest rate that depository banks charge other banks for overnight loans of excess cash from reserve balances. For example, a bank with deposit accounts lends its extra money to another bank that needs fast cash to boost its liquidity. The lending bank pulls from its excess cash reserves for a single overnight period and charges interest on that loan.

The Federal Open Market Committee (FOMC) – the committee within the Federal Reserve System that controls the federal funds rate – can't force banks to charge the federal funds rate. Instead, the banks engaging in the transaction agree to an interest rate for lending and borrowing the money. Still, the rate banks charge each other is influenced by the effective federal funds rate. The reverse is also true — the interest charged between banks affects the federal funds rate.

The Fed can influence interest rates by controlling the country's money supply. More money means lower interest rates, while less money means higher interest rates.

Why was the Federal Funds Rate Created?

The stock market crash of 1929 caused a run on banks that quickly stripped them of liquidity, resulting in a mass failure of banks across the country. In turn, their customers lost their life savings. In response, the federal government created a reserve requirement that forced banks to maintain a percentage of their overall deposits on hand in the form of cash. When a bank runs low on physical money, it can reach out to the federal government or any institutional lender for a quick infusion of cash to maintain its reserves.

Reserve requirements are usually contingent on the number of net transaction accounts a financial institution has.

Banks aren't the only financial institution that have to meet reserve requirements. Credit unions and savings and loan associations must also maintain a certain level of cash in their vaults or at the nearest Federal Reserve bank.

Banks borrow from each other because the interest rates charged by other banks are typically lower than those charged by the government. However, a bank can also borrow from the Federal Reserve during a period known as a discount window. Banks who borrow overnight during the discount window get an interest rate lower than the federal funds rate.

How Does the Federal Funds Rate Work?

The Federal Reserve is the government institution that loans money to banks and other lending institutions. It sets the interest rate when banks borrow money from the Federal Reserve. The FOMC meets eight times yearly to discuss and ultimately set the federal funds target rate.

Open market operation (OMO)—the Fed's policy of selling and purchasing securities on the open market—impacts lending institutions borrowing from the Fed nationwide. The sale or purchase of bonds directly affects banks through an increase or decrease in liquidity.

The sale of bonds lowers liquidity for banks, reduces the amount they have to trade, and raises the federal funds rate. In contrast, the government can buy back bonds, which lowers the federal funds rate and leaves banks with excess liquidity for trading.

How the Federal Funds Rate is Used to Control the Economy

You may have noticed that the media reacts strongly whenever the Federal Reserve raises or lowers rates. That's because the federal funds rate directly impacts the economy in almost all lending areas.

Raising the Fed Funds Rate

Credit cards that tie their interest rates to the federal reserve rate charge more interest on existing balances and purchases when the fed funds rate increases. Mortgage interest rates rise, too, as do auto loans. The overall effect of a higher fed funds rate is drawing more money out of the economy through debt service, leaving the average consumer with less money to spend.

On the surface, raising interest rates is seen as a negative because it impacts individuals' ability to pay for their living expenses. However, when there's too much money circulating freely in the economy, prices spike, and inflationary pressures make it harder for people to buy the basics of daily life.

The FOMC will usually raise the federal funds rate when inflation is high because it draws money out of the economy at all levels, resulting in a leveling out of prices and an eventual return to normal for the cost of most products.

A higher fed funds rate translates to a higher interest rate on savings products (such as your bank account, bank certificates, deposit, and bonds). This encourages people to save more since they can earn a higher return.

Lowering the Fed Funds Rate

Conversely, when there's not enough money circulating in the economy, the FOMC will usually lower the federal reserve rate to reduce the cost of borrowing at the institutional level. Banks are more likely to lend money to consumers because it costs less to borrow from the federal reserve and other lending institutions. A lower rate gets more money circulating in the economy at all levels.

Analysts and investors often react negatively to an increasing federal funds rate as they see it as a negative for the economy. Its importance is undeniable, though. By raising the fed funds rate, the FOMC can curb rising costs, even if it takes time for the lower prices to reach consumers.

An economic theory known as asymmetric price transmission (a.k.a. rockets and feathers) refers to the pricing phenomenon of a sudden spike in prices followed by a slow decline. Gasoline prices are one such example. A disruption in the supply chain can cause gas prices to spike quickly, but it can take weeks for the price to go back down. This is because lower input costs don't immediately translate to lower prices of finished products.

In the same way, the FOMC hopes an increase in the fed funds rate will translate to banks borrowing less, less money entering the economy, and prices dropping. But that usually won't happen right away.

Investors and the Stock Market

It's not just the media that react strongly to news regarding the federal funds rate. The stock market tends to jump on announcements of a lower fed funds rate, as it means companies will be able to borrow more cheaply and hopefully enter a period of expansion.

Similarly, the stock market tends to dip on news of an increased federal funds rate, which signals inflationary pressure and the Fed attempting to curb unsustainable economic growth.

The Federal Reserve is responsible for preventing another economic crash like the one in 1929. Its decisions aren't always popular, but they reach their decision using various economic reports and comments from the 12 reserve banks. The resulting consensus moves the federal funds rate up, down, or maintains the status quo.

The Fed Funds Rate's Impact on Loan Rates

As a general rule, an increase or decrease in the federal funds rate results in a corresponding increase or decrease in the amount of interest charged by lenders. This is because the federal funds rate directly influences the federal prime rate.

The prime rate is what banks will charge their most creditworthy customers – generally 3% higher than the federal funds rate. For example, a federal funds rate of 3.25% results in a prime rate of 6.25%.

Lenders use the prime rate on short- and medium-term loans and lines of credit to consumers, then add extra interest to cover the costs of originating the loan and making a profit. For another example, when the fed funds rate is at 6.25%, a borrower who takes out a $300,000 loan on a home with a 20% down payment can expect to pay 9.25% in interest on a 30-year fixed mortgage.

The prime rate is influenced by the federal interest rate, which applies to all lending institutions across the U.S. But it is not a law. It's possible to find lenders offering loans and lines of credit for less than the prime rate. Always read the terms and conditions when getting a loan from a lender offering interest rates less than the prime rate.

Final Words

The federal funds rate is an integral part of the U.S. financial system. It helps to ensure the banking industry is operating efficiently and helps inflation stabilize when prices threaten to push too high. Investors need to know the current federal funds rate to make better investment decisions with their money in terms of saving and borrowing.

Tracking information from the consumer price index (CPI) and the personal consumption expenditures (PCE) price index ahead of FOMC meetings can help you anticipate what actions the Fed will take to stimulate or curb economic growth.

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