What you'll learn:
➤ What Is the Federal Funds Rate?
The federal funds rate may sound like a complex financial term, but it plays a crucial role in shaping the U.S. economy.
This rate affects various aspects of our financial lives, from the interest we earn on our savings accounts to the cost of carrying credit card balances.
In simple terms, it controls the price of money in the United States.
➤ How Does the Federal Funds Rate Work?
So, how does this rate work? The Federal Open Markets Committee, also known as FOMC, sets the federal funds rate. They define it as a range, with an upper and lower limit. Currently, it stands at 5.25% to 5.50%.
Here’s the basic idea: Customers deposit money into banks, which gives banks the capital they need to lend to their customers and extend credit. To ensure the stability and solvency of banks, regulators require them to keep a certain percentage of their capital in reserve.
Now, the amount of capital in banks fluctuates daily as deposits come and go and loans are approved and repaid. Consequently, their reserve requirements change.
Banks often need to borrow money overnight from other financial institutions to meet these requirements or lend out their excess reserve capital to peers. The federal funds rate serves as a reference point for these transactions.
Federal Funds Rate & Monetary Policy
The federal funds rate also plays a significant role in monetary policy. The Federal Reserve has a “dual mandate”: control inflation and support maximum employment. It also aims to maintain moderate long-term interest rates and a stable financial system.
The fed funds rate influences what banks charge each other for borrowing money, which, in turn, affects the rates they charge customers.
Take, for example, the prime rate, which is a benchmark for consumer and business loans. It closely follows changes in the fed funds rate.
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Federal Funds Rate & Inflation
When the Fed raises this rate, it aims to increase short-term borrowing costs, reducing the supply of credit and making loans more expensive. This can help control inflation by reducing the money circulating in the economy.
Conversely, lowering the fed funds rate has the opposite effect. It reduces short-term interest rates throughout the economy, increasing the money supply and making credit more affordable. This can stimulate hiring and potentially reverse periods of low or negative inflation.
Federal Funds Rate & Economy
But the influence of the federal funds rate goes beyond interest rates. It affects the entire economy.
Expectations about future changes in this rate influence the movement of Treasury yields, which, in turn, impact many forms of credit, such as business, government, and mortgage-backed loans.
Federal Funds Rate & The Stock Market
The stock market is also sensitive to changes in the federal funds rate. When rates are cut, stock markets usually see a boost, as lower borrowing costs can lead to increased business expansion and earnings.
Conversely, when rates rise, equity markets may face challenges, as borrowing becomes more expensive, benefiting lenders with higher rates.
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Who Decides for the Federal Funds Rate?
Historically, the fed funds rate has not been a fixed number. It changes as the Fed responds to economic shifts.
The FOMC conducts eight policy meetings each year to assess the economic landscape and decide whether to keep the fed funds rate steady or adjust it.
Over the past half-century, the federal funds rate has ranged from a low of 0% to a high of 20%. In 1980, it soared to 20% to combat double-digit inflation.
Higher interest rates typically curb borrowing and spending as the cost of accessing lending and credit rises for consumers and businesses.
Conversely, in 2008, during the Great Recession, the Federal Reserve lowered the fed funds rate to 0% to stimulate economic recovery. They did so again in 2020 to mitigate the economic impact of the Covid-19 crisis.
Lower rates make lending and credit more accessible, spurring consumer and business spending and driving economic growth.
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➤ Final Thoughts
In a nutshell, the federal funds rate is not just a number for experts. It’s a tool that shapes the financial landscape and impacts everyone’s financial choices.
Understanding its role can help you navigate the world of money more effectively.
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