Interest rates are at their lowest since 2008 — What does that mean?

Matthew de Silva
Covered finance for Quartz, former SEC intern. BS, Georgetown University.
Takeaway
  • The federal funds rate is the interest rate at which banks borrow from one another on an overnight basis
  • Lowering the fed funds rate helps support the US economy by indirectly lowering the cost of borrowing money for both businesses and consumers
  • The Federal Reserve made two emergency cuts to the fed funds rate in March to address the economic impact of the coronavirus
  • As of April 2020, the fed funds rate is 0–0.25%, the lowest it’s been since the 2008 financial crisis

The spread of COVID-19 might make it feel like the sky is falling. While the virus has disrupted day-to-day life, it’s also shaken the financial markets. In response, in March, the Federal Reserve (aka the Fed) took dramatic action, cutting interest rates down to target 0.00–0.25%, the lowest they’ve been since the 2008 financial crisis.

But what does that mean for you and me? A lot actually. Although the fed funds rate directly affects how much banks pay to borrow from one another, it has much wider implications. It can ultimately influence everything from the interest rates on credit cards and student loans to car payments and mortgages. While interest rates might seem obscure (or even tedious), they’re a fundamental part of what keeps the US economy moving. We’ll break it down for you:

What’s an interest rate?

When a person borrows money from the bank, they usually agree to pay a fee for that service. This fee, which is expressed as a percentage of the total loan, is called the “interest rate.” Interest is basically the cost of borrowing money.

For instance, if a small business owner took out a $40,000 loan to start an ice cream shop, they might agree to a 5% annual interest rate. That means they would commit to repaying the $40,000 loan, the “principal,” plus $2,000 in interest. (This is a hypothetical example, and we’re assuming they can pay off the loan within one year.) Depending on the terms of the loan and the size of your monthly payments, you could pay much, much more in interest. Generally though, the sooner you pay off a loan, the less you’ll pay in interest (and the more money, or capital, you’ll have on hand).

Why do banks charge interest?

Interest is one way that banks earn money. Banks can help the economy by providing loans to small businesses (e.g., ice cream entrepreneurs) and to individuals who want to buy cars and homes, among other things.

In addition to charging interest on loans, say, for credit cards, student loans, or mortgages, banks also earn money through various fees. These might include penalties for late payments, ATM withdrawals fees, or account service fees. Some banks also offer investment services and charge commissions to process those trades.

Wait, then how is the Federal Reserve involved?

The US central bank, or the Federal Reserve, influences interest rates like the ones we mentioned above in an indirect way. Instead of deciding the interest rate on your credit card or your student loan, the Fed sets the “federal funds rate,” the interest rate that depository institutions (aka banks and credit unions) charge one another to borrow funds overnight. Banks might borrow this money in order to meet their reserve requirements or to address short-term needs.

When you hear news anchors and economists talking about interest rates, they usually mean the fed funds rate. Whatever happens to the fed funds rate typically has a ripple effect on the wider economy.

Adjusting the fed funds rate is like training as a weight lifter...

If you want to build muscle, you can incrementally add heavier weights to the barbell. But if you’re straining under the load, you might reduce the weight to something more manageable. The Federal Reserve uses the fed funds rate in a similar fashion. It raises interest rates (adds weight) to control inflation and keep financial risk in check. With higher rates, loans become more expensive, and people are less inclined to borrow money. On the other hand, if the economy is under strain, the Fed might lower the fed funds rate (remove weight). Lower interest rates essentially make it cheaper for people and businesses to borrow money.

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Has the Fed changed the fed funds rate in 2020?

Yes! In March 2020, the Federal Reserve, acting through the Federal Open Markets Committee, lowered the fed funds rate twice. The Fed made an emergency cut on March 3, reducing the target to 1.00 – 1.25%. That day, The New York Times called it a “pre-emptive move to protect the economy from the coronavirus.”* But as COVID-19 spread, the Fed decided to do more. On March 15, 2020, the Fed cut its interest rate target again, bringing the fed funds rate down to 0.00–0.25%.

Enough about interest rates — Does that mean the interest rate will drop on my (insert loan here)?

Sort of. We wish there was a neat answer, but it’s not that simple. It’s an A leads to B, and B leads to C sort of thing.

Here’s how it works: When the Fed lowers the fed funds rate (aka interest rates), individual banks may revise their prime rates. The prime rate is the best rate banks have to offer, and it’s usually reserved for their most creditworthy (read: established, more predictable) corporate customers. Typically, the prime rate is the same across banks, and it’s used to set rates on some consumer loans. While the prime rate is roughly uniform, the interest rate paid on deposits often varies across banks.

Lower interest rates are a double-edged sword. It might become slightly cheaper for you to get a new loan or pay off a credit card. However, if you have a savings account, you may earn less interest on that money. There are pluses and minuses for most everyone.

Depending on your situation, a cash management account could offer you the potential to earn a higher interest rate on your cash compared to other similar options.

Can interest rates go negative?

Yes. In some parts of the world, countries have experimented with negative interest rates. For instance, in 2019, the European Central Bank, the central bank for the Eurozone, implemented a -0.5% interest rate on deposits kept with the central bank. This was meant to encourage banks in the Eurozone to lend more money to businesses and people. The Bank of Japan has also used negative interest rates before.

As of April 2020, the Federal Reserve has never pursued a negative interest rate policy.

What other tools does the Federal Reserve have at its disposal?

In addition to cutting interest rates, the Fed recently announced a massive stimulus plan, pledging to support the economy by buying as much government debt as needed. This includes billions of dollars worth of US Treasury Bonds (aka T-Bills) and mortgage-backed securities. On March 20, the Fed also said it would buy corporate bonds to shore up American business.

What comes next for the Fed?

Operating under a dual mandate to maintain stable prices and maximize sustainable employment, the Fed is in a tough position. Reducing interest rates, as it has, could cause inflation. But meanwhile, there’s a looming threat that the unemployment rate could reach 20–30% by the second quarter of 2020. (And that’s according to estimates from Fed officials.) All we can be certain of is this: The longer COVID-19 carries on, the more it will hurt the US economy and impact its people.

Right now, we’re in need of scientific progress (i.e., a vaccine or treatment for the coronavirus disease), but in the interim, the Fed might act to prop up businesses of all sizes. Some economists suggest that the Fed could collaborate with the Treasury Department to help support small businesses, something that’s outside its normal activity.

Even with Federal Reserve chairman Jerome Powell leading the way, it’s difficult to predict the Fed’s course of action. Much of it depends on how Congress allocates funds to the American public and manages possible industry bailouts. Those factors could have larger effects on the economy, which the Fed can then respond to. At the moment, like much of the world, the Fed is waiting to see how things shake out. We probably won’t know whether the Fed’s policies achieve their desired effect until we’re farther along in the recovery process—both from the global economic slowdown and from COVID-19.

References

  • The New York Times. “Fed Makes Emergency Rate Cut, but Markets Continue Tumbling.” Published March 3, 2020. Updated March 6, 2020. Accessed April 14, 2020. https://www.nytimes.com/2020/03/03/business/economy/fed-rate-cut.html
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