How the Federal Funds Rate Works — and How It Affects You

federal funds rate

There’s a lot of hype about the Federal Reserve raising interest rates this year.

Many analysts think that we’ll see an increase in the federal funds rate at some point this year. There is even speculation that a rate hike could be announced at the March 2017 meeting.

While there’s no way to know what the Federal Reserve will do until it happens, it’s good to understand how the federal funds rate works and what an increase could mean for you.

What is the federal funds rate?

At its basic level, the federal funds rate is the interest rate that financial institutions use when lending each other overnight funds.

Banking institutions are required to have a certain percentage of assets on hand to start their day. Banks keep their reserve funds with the Federal Reserve and they must ensure that they meet the minimum reserve requirements each day.

If a bank is short, it can borrow from the reserves of another bank that has more than it needs. The fed funds rate is the target interest rate that these banks charge each other for overnight funds.

How the federal funds rate is set

The federal funds rate is set by the Federal Open Market Committee (FOMC), which is part of the Federal Reserve. The FOMC meets at various times during the year to discuss monetary policy and make decisions about how the target rate should be set. Voting members of the FOMC decide whether or not to raise or cut the target — and by how much.

It’s important to note that this is a target rate. When people say the Fed is raising interest rates, what they really mean is that the members of the FOMC have chosen a target rate they’d like banks to use in the future.

The Fed can’t actually force banks to lend to each other at that rate. Banks set their own rates based on market conditions.

This is where the FOMC’s actions come into play. Once the Fed sets a target rate, the FOMC takes steps to encourage market conditions to move in a manner that promotes the desired rate.

What factors does the FOMC consider?

When setting a target rate, members of the FOMC consider economic conditions.

If inflation is growing out of control, for example, the Fed can set a higher target to rein it in. In the late 1970s and early 1980s when inflation was reaching double digits, the fed funds rate reached a high of 20 percent, with the effective rate (the average rate across institutions lending each other money) reaching a high of over 19 percent.

On the other hand, if the economy is floundering as it was following the financial crisis of 2008, the FOMC can cut its target rate. At one point, the FOMC opted for a target rate between 0 and 0.25 percent. It stayed at that rate for years.

Federal Reserve employees pore over data and members of the FOMC look at reports to decide what to do. Labor market data, including participation and payrolls, is a major indicator. The yield curve between the 10-year Treasury note and the three-month note is another measure.

Of course, the Fed also pays attention to inflation. In general, the FOMC targets 2 percent inflation because it believes that number promotes price stability and maximum employment.

How the FOMC makes the fed funds rate a reality

Since the Federal Reserve can’t force interest rates on anyone, it has to use monetary policy tools to influence the market so its target can be reached.

Mostly, the FOMC tries to control conditions through the buying and selling of assets. This often includes Treasuries and mortgage-backed securities. This way, the monetary supply can be influenced and rates will follow suit.

For example, when the Fed buys assets in the open market, there’s more money in the system. The Fed has the bonds and there’s more cash available to the general public. When more money is available, it’s cheaper. This encourages consumers to borrow more and banks to lend more. Lower rates mean that money moves through the economy and that, theoretically, means more growth.

On the other hand, when things are heating up too fast for the Fed’s comfort, the FOMC might want to slow things down. Selling some of its assets means taking money out of the economy. When that happens, interest rates rise and money is more expensive. Fewer people borrow and economic activity slows.

The federal funds rates and your finances

Even though this rate is all about banks lending to each other, it still impacts your finances. Other interest rates are set based on the federal funds rate. When banks decide what they will charge you, they start with the fed funds rates since they want to make sure they are charging more than they pay to other banks.

If the fed funds rate goes up, there’s a good chance the interest rates you pay on credit cards, car loans, and home equity lines of credit are going up, too.

For savers, though, a fed rate increase can be a good thing. Higher rates also mean banks are more likely to pay a higher yield on CDs, savings accounts, and other items.

Finally, a fed rate increase or decrease can also impact the stock market. In general, investors like it when rates are low. Businesses can borrow at lower rates, meaning wider margins and potentially better profits. When rates start to rise and the economy is expected to slow, the stock market tends to drop.

In the end, there’s not much you can do about the fed funds rate. But if you follow good financial habits and practices, you can be ready, no matter what the markets and policymakers throw at you.

Worried that rising interest rates will affect you? Take action before rates rise.

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