On July 28, 2021, the Federal Reserve maintained its target for the federal funds rate (the benchmark for most interest rates) at a range of 0% to 0.25%. This was no different from its June 2021 announcement that the target rate would remain unchanged. The Fed's goal is to boost the economy, battered by the coronavirus pandemic. It first lowered the rate to almost 0% on March 15, 2020.
The nation's central bank uses its Federal Open Market Committee (FOMC) to make these decisions. It meets eight times per year.
At its July 2021 meeting, the FOMC had said it intends to keep the benchmark rate at current rock-bottom levels until inflation is at 2% for the long term. It's willing to allow inflation to rise above 2% in the short term if necessary to achieve maximum employment. The Fed expects inflation to increase to 3.4% this year as the economy recovers and drop to 2.1% in 2022.
The fed funds rate is critically tied to the U.S. economic outlook. It directly influences prevailing interest rates such as the prime rate and affects what consumers are charged on credit cards, loans, and mortgages.
The fed funds rate is the interest rate banks charge each other to lend Federal Reserve funds overnight. The nation's central bank relies on it to promote economic stability by raising or lowering the cost of borrowing.
Why the Fed Raises or Lowers Interest Rates
The FOMC's goal is to promote maximum employment, stable prices, and moderate long-term interest rates.
The Fed uses interest rates as a lever to grow the economy or put the brakes on it. If the economy is slowing, the FOMC lowers interest rates to make it cheaper for businesses to borrow money, invest, and create jobs. Lower interest rates also allow consumers to borrow and spend more, which helps spur the economy.
On the other hand, if the economy is growing too fast and inflation is heating up, the Fed may raise interest rates to curtail spending and borrowing.
The last time the Fed cut the fed funds rate to 0.25% was in December 2008. That was to address the 2008 financial crisis.
The rate was at virtually 0% from December 2008 until December 2015. Then, as the economy picked up steam, the Fed began to raise the benchmark, and it rose steadily until 2018.
In 2019, the Fed reversed course, slowly lowering rates to counteract a weak economy. In March 2020, it reacted swiftly to the escalating outbreak of the COVID-19 pandemic. The health crisis rocked not only the financial markets but the broader global economy and everyday life around the world. On March 11, 2020, the World Health Organization declared it a pandemic.
How the Fed Funds Rate Works
The fed funds rate is one of the most significant leading economic indicators in the world. Its importance is psychological as well as financial.
The FOMC targets a specific level for the fed funds rate. It determines the interest rates banks charge one another for overnight loans. Banks use these loans, called the fed funds, to help them meet the cash reserve requirement.
The reserve requirement is also set by the Fed. It is a percentage of deposits a bank must keep on hand each night. Banks that don't have enough to meet the requirement borrow fed funds from banks that have excess. They charge the borrower the fed funds rate.
Along with cutting its benchmark rate, the Fed lowered the reserve requirement to 0% in March 2020.
The move encourages lending to households and businesses in need. The new requirement took effect on March 26, 2020.
The Fed manages the fed funds rate with open market operations. It buys or sells U.S. government securities from Federal Reserve member banks. When the Fed buys securities, that purchase increases the reserves of the bank associated with the sale, which makes the bank more likely to lend. To attract borrowers, the bank lowers interest rates, including the rate it charges other banks.
When the Fed sells a security, the opposite happens. Bank reserves fall, making the bank more likely to borrow and causing the fed funds rate to rise. These shifts in the fed funds rate ripple through the rest of the credit markets, influencing other short-term interest rates such as savings, bank loans, credit card interest rates, and adjustable-rate mortgages.
The Fed's actions during the financial crisis sent banks’ reserve balances soaring. As a result, they no longer had to borrow from one another to meet reserve requirements.
- In July 2021, the Federal Reserve maintained its target for the federal funds rate at a range of 0% to 0.25%.
- Prior to March 2020, the last time the Fed cut interest rates to this level was December 2008. It remained there until December 2015.
- The fed funds rate directly influences prevailing interest rates such as the prime rate and what consumers are charged on credit cards, loans, and mortgages.