Current Federal Reserve Interest Rates and Why They Change

Why the Fed Lowered Its Benchmark Rate in October 2019

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The interest rate targeted by the Federal Reserve, the federal funds rate, is currently 1.75%. That’s after the Fed cut it a quarter of a percentage point on Oct. 30, 2019. The federal funds rate is the benchmark interest rate banks charge each other for overnight loans. It generally reflects the health of the economy and has a big impact on other interest rates. The Oct. 30 cut was the third rate drop in 2019, after years of steady increases following the Great Recession.

The Federal Reserve is the central bank of the United States and it is mandated by Congress to promote economic stability, mainly by raising or lowering the cost of borrowing. The Fed said it lowered interest rates because, although the U.S. economy is strong and unemployment is low, business investments and exports have continued to be "weak" since the previous meeting of the Federal Open Market Committee on Sept. 18, 2019. The FOMC is the Fed’s rate-setting body, and it votes on interest rate changes every six weeks or so. The FOMC looks at where it thinks the economy is headed and sets interest rates to help the economy reach or maintain full employment, moderate long-term interest rates, and an inflation rate of 2%.  

The fed funds rate is critical in determining the U.S. economic outlook. It is used to set short-term interest rates, including banks' prime rate (the rate banks charge customers for loans), most adjustable-rate mortgages, and credit card rates. 

Why the Fed Raises or Lowers 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 Fed can lower interest rates to make it cheaper for businesses to borrow money, invest, and create jobs. Lower interest rates also tend to make consumers more eager to borrow and spend, 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. 

In December 2008, the Fed cut the fed funds rate to 0.25%. That’s effectively nothing. It did so amid the worst financial crisis since the Great Depression, in an effort to light a spark under the economy. The rate stayed unchanged until 2015, and rose steadily through 2018 as the economy picked up steam. The 2019 cuts are a sign that growth is beginning to slow.

How the Fed Funds Rate Works

The FOMC targets a specific level for the fed funds rate, which determines the interest rates banks actually charge one another for overnight loans. Banks use these loans to help them meet cash reserve requirements: Banks that are short borrow from banks that have excess. 

A reserve requirement is the amount of cash a bank must keep overnight. It’s set by the Fed and is a percentage of the bank’s deposits. The current top reserve requirement is 10% for banks with more than $124.2 million on deposit. 

Prior to the financial crisis, the Fed controlled the fed funds rate by buying and selling U.S. government securities on the open market. When the Fed buys a security, that 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, 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.

Actions the Fed took during the financial crisis and throughout the recession that followed had the effect of ballooning banks’ reserve balances, and as a result, banks didn’t need to borrow from one another to meet reserve requirements. The Federal Reserve could no longer rely on reserve balance manipulation to control interest rates. Because of that, the Fed has developed other tools to affect the rate.  

How the Fed Now Sets the Fed Funds Rate

Today, the Fed sets a target range for the fed funds rate. It started back in October 2008, when the Fed began paying interest on reserves (IOR), but to a limited number of institutions. This was intended as the floor on the fed funds rate. After all, banks won’t lend to each other at a lower rate than what they’re getting from the Fed.

But eventually, the Fed realized the IOR wasn’t sufficient. It needed a sub-floor, so in 2013 it added another tool to help it control the target rate: the overnight reverse repurchase agreement facility (ON RRP, or “reverse repo”). This program is available to a broader range of financial institutions than IOR. 

With the ON RPP, the Fed agrees to sell a security and buy it back at a higher price, which is effectively the interest rate. This rate is set high enough to attract buyers, but below IOR. When banks need to borrow from one another, they do so within the range bounded by IOR and ON RPP. And when the Fed acts to raise or lower interest rates, it adjusts both IOR and ON RPP. 

How Other Interest Rates Are Determined

The fed funds rate is one of the most significant leading economic indicators in the world. Its importance is psychological as well as financial, as many of the interest rates businesses and consumers pay are based on it, if only indirectly. For example, the prime lending rate is determined by individual banks themselves, who base their rates on the fed funds rate.

Variable interest rates for credit cards and other consumer loans, for example, rely on the prime rate, which means they’re also affected by the fed funds rate.   

However, not all loans rely on the prime lending rate. In fact, the interest rates for 30-year mortgages correlate with the yield on the 10-year Treasury note. That’s because investors who are interested in safe long-term returns on their investments see lots in common between the two—but not because one rate is determined by the other. Ultimately, supply and demand determine the rates for both.

Another important benchmark interest rate that is not set by the Fed is the London Interbank Offered Rate (LIBOR). It is the average interest rate major global banks charge each other to borrow. LIBOR is calculated daily, and is the basis for a host of commercial and consumer interest rates, from corporate bonds to adjustable-rate mortgages. 

The Bottom Line

The interest rate set on the excess reserves that banks can lend to each other refers to the Federal Reserve interest rate. This rate is important because:

  • It influences short-term rates such as those on credit cards, home loans, auto loans, and consumer loans.
  • It is a leading economic indicator and a monetary tool. A rate increase is used to curtail inflation while its reduction may signal a slowdown in economic growth.
  • It may also influence the stock market.

The FOMC sets the fed funds rate eight times a year. It bases its target rate on current economic conditions.

During the 2008 recession, the Fed realized it could not rely on reserve balance manipulation alone. There was a ballooning excess of reserves. So, it added the reverse repo facility (ON RRP) to help manage the target fed funds rate.

 

Article Sources

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  13. U. S. Securities Exchange Commission: "Statement on LIBOR Transition," Accessed Sept. 19, 2019.