The fed funds rate is the interest rate banks charge each other to lend Federal Reserve funds overnight. The nation’s central bank uses it in addition to other tools to promote economic stability by raising or lowering the cost of borrowing. The nation’s central bank uses its Federal Open Market Committee (FOMC) to make decisions about interest rates. It meets eight times per year to discuss current conditions and decide what actions to take.
Why Federal Reserve Interest Rates Matter to You
The Federal Reserve’s goal is to promote maximum employment, stable prices, and moderate long-term interest rates. The Fed uses interest rates as a lever to grow the economy or put the brakes on it. If the economy is slowing, the Fed lowers interest rates to make it cheaper for businesses to borrow money, invest, and create jobs. Lower interest rates also allow consumers to borrow and spend more, which also helps spur the economy. On the other hand, if the economy is growing too fast and inflation is heating up, the Fed is likely to raise interest rates to curtail spending and borrowing. For those of us who live in the economy, the Fed’s interest rate moves affect our borrowing costs. If the Fed’s moves are successful, we may enjoy a robust economy, with plenty of jobs. And if not, we may be mired in recession.
How the Fed Funds Rate Works
The fed funds rate is one of the most significant leading economic indicators in the world. Its importance is psychological as well as financial. The FOMC targets a specific level for the fed funds rate and uses a couple of tools to reach it. In one, the Federal Reserve pays interest to banks on funds that certain banks deposit with the central bank, called “Interest on Reserve Balances.” This rate influences the interest rate the banks charge each other for short-term loans. Banks use these loans to help them manage their businesses. A lower federal funds rate encourages banks to lend more to households and businesses because they make more money from these loans than from lending each other their reserves. Traditionally, the Fed manages the fed funds rate with open market operations. It buys or sells U.S. government securities from Federal Reserve member banks. When the Fed buys securities, that purchase increases the reserves of the bank associated with the sale, which makes the bank more likely to lend. To attract borrowers, the bank lowers interest rates, including the rate it charges other banks. When the Fed sells a security, the opposite happens. Bank reserves fall, making the bank more likely to borrow and causing the fed funds rate to rise. These shifts in the fed funds rate ripple through the rest of the credit markets, influencing other short-term interest rates such as savings, bank loans, credit card interest rates, and adjustable-rate mortgages. The Fed’s actions during the financial crisis sent banks’ reserve balances soaring. As a result, they no longer had to borrow from one another to meet reserve requirements.
