Following the July 2022 FOMC meeting, the Federal Reserve raised the target federal funds rate by another 0.75 percentage points (or 75 basis points), as part of an effort to suppress rising inflation.

During this steep period of rate hikes, there can be a lot of questions about what exactly the federal funds rate is and how it impacts the US economy.

Recent History of Fed Funds Rate Changes

What Is The Federal Funds Rate?

The effective Federal Funds Rate (FFR) is the average interest rate that banks pay for overnight borrowing in the federal funds market, set by the Federal Reserve, the central bank of the United States.

The Fed Funds Rate is set as a target range according to the Fed’s policy goals and the economic conditions of the US. It directs the Federal Reserve Banks to influence the rate towards that range with open market operations or adjustments to their own deposit interest rates.

Colloquially, the FFR is referred to as just “interest rates” as they represent the overall average rate charged. However, the effect is not immediate and depends on the banks’ response to money market conditions. Target ranges are announced at the Federal Open Market Committee (FOMC) meetings.

How Is the Fed Funds Rate Determined?

The Federal Open Market Committee (FOMC) customarily meets eight times a year to set a target range for the federal funds rate. The FOMC is comprised of twelve voting members including the Fed Chair (currently Jerome Powell), the vice-chair, the Board of Governors of the Federal Reserve System, and four other regional Federal Reserve Bank presidents.

The Fed has two primary objectives: maintain stable prices and maximize employment. To achieve these goals the Fed implements monetary policy, one of which is raising or lowering interest rates.

When unemployment is high, the FOMC implements an expansionary monetary policy — boosting economic growth by increasing the money supply and lowering rates. Lower rates and more cash in the system influence consumers to spend more, which in turn should spur economic growth and reduce unemployment.

If the economy grows too quickly, prices rise and inflation occurs. The FOMC responds to rapid inflation with a contractionary monetary policy — making it more expensive to borrow and therefore slowing the economy down. A slower economy forces businesses to maintain price levels in order to keep customers; sometimes businesses even lower prices in order to gain customers. This should lower inflation by tamping down economic activity.

The rate by which the Fed changes the target rate depends on how significant of a concern rising inflation or unemployment is. The standard movement of rates is a quarter of a percentage point (or 25 basis points).

However, in an emergency response to the Covid-19 pandemic, the FOMC lowered the target rate by a total of 1.5 percentage points (150 basis points) in March 2020. During this period, the fed funds rate was the lowest it had been since December 2008 – December 2015 as a reaction to the financial crisis of 2008.

How Fed Funds Work

The Federal Reserve historically required banks to maintain liquid assets each night to cover sustained net cash outflows. The Fed reduced the reserve ratio to 0% as of March 2020.

Without a reserve ratio, financial institutions are still able to hold capital in reserves for other depository institutions to borrow from, and the Fed pays them interest on the reserves they keep (the IORB). A bank borrows from another bank’s reserve if it is short of cash at the end of a business day. This is where the fed funds rate applies, it is the rate that banks charge one another for overnight loans.

How Monetary Policy Impacts the Economy

The FOMC implements monetary policy to influence interest rates and the economy. The two tools used to keep the fed funds rate in the target rate range include:

1. Interest On Reserve Balances (IORB): The Fed pays interest on the reserves that banks keep with it.
2. Overnight reverse repurchases (ON RRP): The Fed sells securities to banks that aren’t eligible for interest on reserve balances. It then buys them back at a higher price the next day, essentially paying the bank interest.
3. Discount Rate: The interest rate charged by the Federal Reserve to banks for loans obtained through the Fed’s discount window.

The FOMC sets a target range for the rate and then sets the IORB and ON RRP rates to manage the effective FFR. Banks then charge each other interest on loans that reflect these changes. In turn, these rates dictate the rates banks charge their customers, influencing business and consumer spending.

Influencing the FFR helps the Fed manage inflation, promote maximum employment, and keep interest rates moderate. The FOMC members monitor the core inflation rate for long-term signs of inflation and adjust rates accordingly.

It can take months for a change in the rate to affect the entire economy. Planning that far ahead has led to the Fed becoming a key source for forecasting economic performance.

Many investors watch the monthly FOMC meetings to try and decode what the Fed will do in future months as the stock market reacts greatly to movement by the Federal Reserve Bank.

Why is the Fed Funds Rate Important?

The federal funds rate is one of the most important benchmarks in the US financial market because it affects both monetary and fiscal conditions which, in turn, impact the broader economy including growth, inflation, and employment.

Interest Rates Affected by the Fed Funds Rate

The prime rate, referring to the prevailing interest rates that banks charge their top clients, is one of the most significant rates influenced by the FFR. The prime rate affects many consumer interest rates including deposits, auto loans, credit cards, and mortgage rates.

The FFR also indirectly affects even longer-term interest rates. Investors want a higher rate for a longer-term Treasury note. The yields on Treasury notes indirectly drive long-term conventional mortgage interest rates.

What is the difference between the Fed Funds Rate and Interest Rates?

Both the Fed Funds Rate and interest rates are some of the most important financial indicators in the US. The main distinction is the fed funds rate sets the range that banks will lend or borrow to each other overnight. Because this impacts borrowing costs and financial conditions, stock markets are typically sensitive to changes in these rates. The fed funds rate also indirectly affects short-term interest rates. On the other hand, interest rates, which are set by the Federal Reserve, determine the rate that it costs for banks to borrow.

The Bottom Line

During economic crises, the central bank can utilize monetary policy to either reduce unemployment or slow down inflation. The Fed keeps a keen eye on inflation, unemployment, and impending recessions in order to determine what tools should be utilized.

Monetary policy is implemented to increase or lower the cost of borrowing so that firms and households can spend more or less with the goal of maintaining a steady and consistent economy.

This material is provided for informational and educational purposes only.  It is not intended to be investment advice and should not be relied on to form the basis of an investment decision.