What is the Federal Funds Rate?

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Definition:

The federal funds rate is the interest rate banks charge each other for overnight loans — It’s one lever the Federal Reserve uses to stabilize the economy.

🤔 Understanding the federal funds rate

The Federal Reserve, the nation’s central bank, requires US banks to maintain a certain level of cash reserves at all times. Banks often loan each other money overnight to stay at this level. The federal funds rate is the interest rate they charge one another for these loans. The Fed sets a target for the federal funds rate eight times a year, based on whether it wants to boost or restrain the economy. It can’t change the rate directly, but it buys and sells securities to influence the rate. Historically, it has been as low as 0 percent and as high as nearly 20 percent. The federal funds rate also helps determine the short-term interest rates you might get for credit cards or certain loans.

Example

Suppose the country was going through a period of inflation (a general increase in the prices of goods and services), and the Federal Reserve wanted to slow it down. The Fed might set a higher target federal funds rate, then sell government securities to achieve this. When interest rates rise, consumers borrow and spend less, which helps curb inflation.

Takeaway

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 tap 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 moving a little too quickly and causing inflation, and lower it if the economy needs a boost.

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Why is the federal funds rate important?

The Federal Reserve, the US 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.

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.

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.

How does the Fed raise the federal funds rate?

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 within the Federal Reserve is tasked with handling open market operations, which includes setting the target federal funds rate. The 12-member committee meets eight 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 US is experiencing a recession, and the Fed wants to expand the economy by cutting interest rates. The Fed can buy government securities, which puts money into the hands of the banks, businesses, and individuals who sold the securities. That money is then available for commercial banks to lend to customers. Banks lower their interest rates to entice customers to borrow the money. That includes the rate they charge each other (the federal funds rate). When interest rates are lower, people take out more loans and spend more money. When people spend more money, the economy grows.

On the other hand, in times of rapid inflation, the Fed might decide to use contractionary monetary policy and increase interest rates. In that case, it can sell government securities, which takes cash out of bank accounts and gives it to the Fed. Because the supply of money goes down, the price of borrowing goes up, and banks charge higher interest rates on loans — including on loans to each other.

Why does the Fed raise or lower the federal funds rate?

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). 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 generally high, but inflation is also growing rapidly. 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 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.

What is the difference between the federal funds rate and the discount rate?

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.

Each type of credit comes with a different discount rate. The rates as of April 1, 2020, were:

  • Primary credit: 0.25%
  • Secondary credit: 0.75%
  • Seasonal credit: 0.80%

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.

What is the current federal funds rate?

Usually, the Federal Open Market Committee (FOMC) changes target federal fund rates just a few times each year.

In 2019, the committee only adjusted the rate three times, all during the second half of the year. Each time, it lowered the rate by 0.25 percent. As always, the FOMC reduced the federal funds rate to stimulate economic growth.

In March 2020, the Fed reduced the target federal funds rate twice in response to the economic downturn resulting from the outbreak of COVID-19. On March 3, the FOMC dropped the target rate from 1.50-1.75 percent to 1-1.25 percent. On March 16, the FOMC cut rates again to 0-0.25 percent. This is where the rate was between the end of 2008 and the end of 2015, as the country recovered from the Great Recession. It is also the lowest federal funds rate in history.

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.

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The free stock offer is available to new users only, subject to the terms and conditions at rbnhd.co/freestock. Free stock chosen randomly from the program’s inventory. Securities trading is offered through Robinhood Financial LLC.

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