Federal Funds Rate

The Federal Reserve is responsible for guiding the U.S. economy during normal times and through disruptive events by setting monetary policy to promote maximum employment and ensure stable prices.

The federal funds rate (FFR), also known as the fed funds rate, is one of the monetary tools the Federal Reserve uses to direct the U.S. economy in the desired direction. It is often set as a range with a lower and upper bound.

For example, the ranges are from January 29, 2020, to January 27, 2021.

It is common to hear that, for example, if the FFR changed by a total of 1.5%, it changed by 1.5 percentage points or 150 basis points. These all mean the rate changed by 1.5%.

The FFR is often considered the most important interest rate in the United States because of its potential effect on countless elements of the economy, such as savings account interest rates, the value of the U.S. dollar, and personal loan interest rates.

Specifically, the Federal Open Market Committee (FOMC), the policy-making body of the Federal Reserve, meets eight times throughout the year to adjust this rate to influence economic growth.

The Federal Reserve is primarily tasked with:

• Controlling inflation
• Minimizing unemployment
• Maintaining the stability of financial systems

Most banks do not have a significant amount of cash because the majority of deposits are given out in the form of loans or other types of credit.

However, all banks must maintain a certain amount of cash that can be distributed in the event of a mass withdrawal trend among customers. This reserve requirement is a percentage of their total deposits.

This cash is stored in a non-interest-bearing account at a Federal Reserve Bank to ensure all customers have access to their cash in case of any economic changes.

This was established following the Great Depression, during which borrowers were unable to withdraw their own money because banks were not required to hold a certain percentage of reserves.

So, when everyone was anxious about the economic condition of the United States, the financial system was flooded with bank runs. As a result, many banks were forced to liquidate loans and shut down.

FFR is the interest rate commercial banks pay when they borrow and lend to each other overnight. Some banks are able to lend their money when they have excess reserves, while others may need to borrow money to abide by the reserve requirement.

A bank's reserve requirement is changing daily as a result of depositors and borrowers. Every day customers deposit and withdraw funds while the bank approves and receives payment for loans.

The fed funds rate can affect many microeconomic and macroeconomic elements of society, such as:

• Interest rates on savings accounts and certificates of deposit
• Loan interest rates (personal, business, credit cards, etc.)
• Interest rate banks must pay to borrow excess reserves from other banks
• Adjustable-rate mortgages
• Home equity lines of credit
• Money supply in the economy
• Inflation
• Unemployment

So, when the Fed funds rate changes, everything that this rate affects tends to change. For example, if this rate increases, the interest that banks pay out to saving account customers may increase as well.

The FOMC can adjust the rate if they anticipate changes in the economy or notice signs of other issues such as rising inflation or abrupt changes in consumer spending.

Some indicators that the FOMC will look at are:

• Current economic conditions
• Core inflation rate
• Durable goods orders report

The fed funds rate has varied between as high as 20% in the 1980s and as low as 0% in the late 2000s during the Great Recession and late early 2020s amid the COVID-19 pandemic.

Understanding the Rate

Fluctuations of the fed funds rate have macro and microeconomic effects. It is important to be aware of changes in this rate because they can significantly impact your financial situation.

The fed funds rate is often considered the most important interest rate in the United States, so it is important to understand what it is.

When the U.S. economy faces high inflation, record unemployment, or a looming recession, the Federal Reserve adjusts the federal reserve rate to guide the economy in a better direction. So what individuals make up the FOMC?

The Federal Reserve was given authority over setting monetary policy by the Federal Reserve Act of 1913. Twelve individuals comprise the FOMC, and some members serve temporarily:

• Seven members of the Board of Governors of the Federal Reserve System
• President of the Federal Reserve Bank of New York
• 4 of the remaining 11 Reserve Bank presidents

The four members from the other Reserve Banks (excluding the Federal Reserve Bank of New York) serve one-year terms and rotate. The annual rotation includes one president from each group of Reserve Banks:

• Boston / Philadelphia / Richmond
• Cleveland / Chicago
• Atlanta / St. Louis / Dallas
• Minneapolis / Kansas City / San Francisco

When not serving their one-year term, the remaining Reserve Bank presidents still attend meetings of the Committee but only participate in discussions as they do not have a vote.

Impact on Economy

When the FOMC increases the rate, the goal is to increase short-term borrowing costs. As a result of increased interest rates that require borrowers to pay more, the supply of credit in the economy is reduced.

When fewer loans are taken out, the amount of money circulating in the economy is reduced. Increasing the federal funds rate is commonly used to curb rising inflation.

When the rate decreases, the FOMC is looking to make borrowing cheaper. More borrowing leads to an increase in the supply of money. This strategy may be deployed in the event of low or negative inflation.

Decreasing the rate can also be effective in minimizing unemployment because it is cheaper for companies to grow and hire talents when they can borrow more money.

Fluctuations in the federal funds rate can significantly affect the entire economy and the stock market.

1. Employment

To minimize unemployment, the Federal Reserve can lower the FFR to make borrowing cheaper. As a result, consumers have more money to spend, and the money supply increases when consumers spend more, and the demand for goods and services increases.

Employers must hire more workers when demand increases the supply, as businesses want to function at the equilibrium point where demand equals supply.

The Fed consequently sets a target rate to maintain this lower level of unemployment.

Lowering the interest rate range is known as "expansionary monetary policy" because it grows the economy.

2. Inflation

The Fed will often increase the fed funds rate to increase the cost of loans and slow the economy. As a result, consumers and businesses will spend less, and companies will grow slower.

Contrasting to controlling unemployment, with higher interest rates, mortgages become more expensive. This slows the housing industry's growth, which causes homeowners to have less equity in their homes because their house prices have gone down.

Consequently, individuals may spend less, which decreases the money supply and helps manage inflation.

The raising of the interest rate range is known as "contractionary monetary policy" because it slows the economy.

Impact on Banks

The fed funds rate does not set the interest rate banks pay depositors but rather influences its direction.

The FOMC sets a target federal interest rate, but the actual interest rate that a bank pays to lenders is a result of the negotiation between the two banks. The average of these overnight lending and borrowing transactions is called the effective federal funds rate (EFFR).

When the Federal Reserve adjusts the federal interest rate, it changes the money supply. This change pushes short-term interest rates toward the target rate that the FOMC sets.

When the money supply is increased, it can cause interest rates to fall. And conversely, when the total money supply is decreased, interest rates can rise.

Additionally, the Federal Reserve also sets a discount rate, determining the interest commercial banks pay to borrow cash directly from the Fed.

Typically, the discount rate is higher than the federal funds rate. As a result, banks normally borrow more from other banks than the Fed.

As mentioned above, the Fed funds rate determines how much interest commercial banks must pay other banks to borrow their excess reserves, so an increase in the rate results in banks paying more interest.

Impact on Individuals

Paying attention to the federal funds rate can be helpful for making an investment, home owning, and loan decisions.

1. Stock Market

When the overnight lending rate is decreased, businesses are able to borrow more money. This increase in borrowing usually leads to more growth. Oftentimes, when the rate decreases, future projected earnings increase.

While this is not always the case, being aware of the changes in the fed funds rate can provide more insight into investment decisions.

2. Bonds

Bonds prices have an inverse relationship with interest rates. Typically, when interest rates increase, bond prices decrease. And when interest rates decrease, bond prices increase.

This is because when interest rates rise, the lower fixed interest rate that the bond pays is less appealing, which causes the price to decline.

3. Savings Accounts and Certificates of Deposits

Changes in the fed funds rate can, but do not always, affect the interest rate you earn on your deposits. For example, with savings accounts, an increase in the federal reserve rate typically increases the savings account interest rate.

With certificates of deposits, you may consider locking in the fixed interest rate of your deposit when the federal interest rate is higher, so you earn a better interest rate even if the federal funds rate decreases.

4. Credit Cards

Credit cards are associated with prime rates. The prime rate is the interest rate charged to their most reliable and safest customers. In other words, this is the best rate you could get from that agency.

The prime rate generally hovers three percentage points (3%) above the federal interest rate.

When the federal interest rate changes, the interest rate or APR dictated by your credit lending agency can change along with it.

5. Home Owning

Fixed-mortgage holders do not have to worry about fluctuations in the interest rate, but other mortgages are subject to adjustments.

While the Fed does not directly impact mortgages, it does affect the 10-year Treasury yield, which follows a similar track. Treasury notes are one of the safest investments because the U.S. government backs them.

Mortgage-backed securities derive their value from the value of the respective home loans. When the Treasury yield increases, investors demand higher rates of return on their mortgage-backed securities.

This is to make up for the increased risk with mortgage-backed securities. As a result, interest rate payments for future homeowners increases.

The interest you will pay is crucial in deciding on buying a house because you will likely be paying off that mortgage for years. So, housing purchases are more common when the federal interest rate is low because home buyers pay less on their mortgages.

The prime rate is often used as the benchmark in setting home equity lines of credit.

6. Loans

Other types of loans, such as student and car loans, are also affected by the federal funds rate. Similar to buying a house, taking out a loan is more enticing when the Fed funds rate is lower, so you pay less interest.

Researched and authored by Jackson Hartz | LinkedIn

Reviewed and edited by Hongmo Liu | LinkedIn

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Black Swan Event
• Federal Reserve (The Fed)
• Financial Industry Regulatory Authority (FINRA)
• Volcker Rule
• White-Collar Crime