What's the Federal Funds Rate?

The federal funds rate is like the gas and brake pedals for the economy...

If you need to speed up while driving, you step on the gas. If you’re going too fast, you can hit the brakes. The Federal Reserve uses the federal funds rate in the same way to speed up or slow down the economy. It might raise the target rate if the economy is growing too quickly and causing inflation, and lower it if the economy needs a boost.

The Federal Reserve, the U.S. central bank, has the power to set reserve requirements for commercial banks. This dictates the amount of cash banks must have on hand, either in their vaults or on deposit with the Federal Reserve, at all times. Changing these requirements (which the bank doesn’t often do) is one way it can affect the money supply and interest rates. In response to the pandemic, the requirement was set to 0% in 2020 to help stimulate lending and the economy.

Banks often lend money to each other to ensure they meet reserve requirements. The federal funds rate is the interest rate that banks and credit unions charge one another to borrow money overnight. The Fed uses tools at its disposal to push the federal funds rate up or down, in order to boost or restrain the economy.

The federal funds rate doesn’t just impact banks — It also has a direct impact on your finances. As the federal funds rate goes down, so can interest rates for certain credit cards, car loans, mortgages, and other loans, although by how much and how soon varies widely. That means not only might you get lower rates for new debt, but rates on existing debt (like adjustable-rate mortgages or your credit card) may decrease.

While it’s often good news for consumers when rates go down, that’s not always the case. For example, interest rates on high-yield savings accounts and certificates of deposit (CDs) are likely to drop as well. Note: CDs and savings accounts aren’t currently offered at Robinhood.

On the other hand, if the Fed increases the target federal funds rate, borrowing becomes more expensive. As a result, rates on certain new loans may rise, and your existing adjustable-rate mortgages and other variable-rate debts will probably see a higher rate.

Investors also pay attention to the federal funds rate, since an increase or decrease can sway the stock market.

The Federal Reserve Act of 1913 gave the Federal Reserve the power to enact monetary policy, or policies and actions that affect the economy by influencing the supply of money. The Fed does this through three primary tools: open market operations, the discount rate, and reserve requirements.

The Federal Open Market Committee (FOMC) within the Federal Reserve is tasked with handling open market operations, which includes setting the target federal funds rate. The 12-member committee meets 8 times a year to analyze and discuss current economic conditions and agree on any changes needed.

The Fed can’t actually set a specific federal funds rate. Instead, it tries to hit the target rate by buying and selling securities.

Suppose the U.S. is experiencing a recession, and the Fed wants to expand the economy by lowering the federal funds rate. To do this, the Fed conducts open market operations by purchasing government securities from banks, increasing their reserves. With more reserves, banks are more willing to lend to each other at lower rates, pushing down the federal funds rate. As this key rate falls, it encourages banks to reduce the interest rates they charge customers, making borrowing more affordable and supporting increased spending and investment, which can help spur economic growth.

On the other hand, in times of rapid inflation, the Fed might decide to use contractionary monetary policy to slow the economy and stabilize prices. In that case, it will raise the fed funds rate. Because the price of borrowing goes up, banks charge higher interest rates on loans — including on loans to each other – the action typically slows economic growth.

The primary goals of the Federal Reserve are to keep employment high and inflation low and stable (the Fed’s target inflation rate is currently 2 percent a year). This is known as the Fed’s dual mandate. These two goals are often at odds, because the Fed has to use expansionary monetary policy to grow employment and contractionary policy to lower inflation.

When employment is high, that usually means the economy is growing, which typically results in inflation. This becomes a problem when the inflation rate exceeds the Fed’s target. When inflation slows, it’s generally a sign that the economy as a whole is slowing down, which can reduce employment. Because of that, the Federal Reserve is in a constant balancing act to achieve both of its goals. To do so, the Fed uses two types of monetary policy: expansionary and contractionary.

During a downturn, when both employment and inflation are generally low, the Fed uses expansionary policy to stimulate the economy. It increases the demand for loans by increasing the money in circulation and lowering the federal funds rate. Because loans are more affordable, people are more likely to borrow money to make large purchases or grow their businesses, which results in higher employment and economic growth.

On the other hand, when the economy is booming, employment is typically high, but inflation might also be rising. To slow inflation, the Fed might use contractionary policy to reduce the supply of money and increase interest rates. By causing the federal funds rate to rise, it raises the rates available to consumers on loans and credit cards. When that happens, people tend to borrow and spend less money, which slows the economy and inflation.

Overall, the Fed’s goal in influencing the federal funds rate is to encourage or reduce demand for goods and services in order to stabilize the economy.

The Federal Reserve also sets a different interest rate called the discount rate. This is the rate at which the Fed lends money to commercial banks and other financial institutions, like credit unions.

The act of the Federal Reserve lending money to banks is called the discount window. The Fed uses the discount window to help keep the banking system stable and ensure households and businesses can access the credit they need.

The Fed offers three types of loans to banks:

• Primary credit is for lending institutions in sound financial condition. It’s like a consumer getting a better deal on a loan because they have an excellent credit score.
• Secondary credit is for those institutions that can’t get primary credit.
• Seasonal credit is for smaller institutions dealing with seasonal swings in loans and deposits.

The Fed intentionally sets the target federal funds rate lower than the discount rate. That’s because, in general, it wants banks to borrow money from one another instead of borrowing from the Fed.

Usually, the FOMC changes the target federal fund rate just a few times each year, but can raise or lower it more or less depending on economic conditions.

For example, during the COVID-19 pandemic, the Federal Reserve took aggressive actions to stabilize the U.S. economy and cut the federal funds rate to near 0 percent in March 2020 to stimulate borrowing and spending.

From March 2020 to March 2022, the FOMC maintained the rate at near 0 percent. The FOMC kept this historic low rate in response to the economic downturn resulting from the outbreak of COVID-19.

Then, beginning in early 2022, the FOMC took an opposite approach and raised rates a total of 6 times. The first rate hike in March was 0.25 percent, followed by a 0.5 percent increase in May. Subsequent rate increases of 0.75 percent occurred in June, July, September, and November. This marked 6 consecutive meetings with rate hikes, as the FOMC sought to curb high inflation, which was at 7.7 percent as of November 2022. It continued to raise rates through the middle of 2023 and, when all was said and done, had implemented 11 rate increases during the inflation fight.

Some European countries and Japan have adopted negative interest rates, but the Fed never has. The highest federal funds rate the Fed ever set was nearly 20 percent in 1981, when the country was experiencing double-digit inflation.