At its June meeting, the Federal Reserve announced that it would be increasing its target for the federal funds rate (the benchmark for most interest rates) by 0.75% to a range of 1.5% to 1.75%. The announcement comes as inflation hits record highs.
The Fed began raising rates in March, marking the first increase since 2018. Throughout the COVID-19 pandemic, the Fed has maintained a near-zero target interest rate.
The Fed's Current Goals
While the Fed's goal is to support the economy as it continues to rebound from the coronavirus pandemic, it also aims to combat the effects of elevated inflation.
The nation's central bank uses its Federal Open Market Committee (FOMC) to make these decisions. It meets eight times per year to discuss current conditions and decide what actions to take.
The committee had attempted to reach a point where inflation averages 2% over the long term by allowing inflation to rise moderately above 2% in the short term.
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 uses it in addition to other tools 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 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 Fed sets a reserve requirement, which is a percentage of deposits a bank must keep on hand each night. If banks don't have enough capital to meet the requirement, they borrow federal funds from banks that have excess. The federal funds rate is the interest charged on these loans.
Along with cutting its benchmark rate, the Fed lowered the reserve requirement to 0% in March 2020.
A lower federal funds rate encourages banks to lend more to households and businesses because they make more money from these loans than from lending each other their reserves.
Traditionally, 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 June, the Federal Reserve announced that it would raise interest rates by 0.75%, shifting the target range to 0.75% to 1.75%.
- During the Covid-19 pandemic, the interest rate was kept at a near-zero range but has changed course as inflation has surged.
- 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.
Frequently Asked Questions (FAQs)
How are the federal funds rate and discount rate different?
While the federal funds rate reflects the rate that banks charge each other for borrowing reserve funds, the discount rate is what the Federal Reserve charges its member banks to borrow funds directly from the Fed to cover temporary shortfalls. The fed funds rate is influenced by actions of the Federal Open Market Committee but is ultimately set by the market, and it varies slightly across the different Fed banks. The discount rate, on the other hand, is set by the Fed's board and is the same for every bank in the Fed.
Why is the federal funds rate so influential on other interest rates?
The fed funds rate affects other interest rates because it determines whether banks can make more money by lending to each other or by lending to other borrowers. When the fed funds rate is very low, banks will be better off lending to others. Although other rates will rise when the fed funds rate rises, fewer consumers and businesses will seek loans at those high rates, thus slowing down lending on the open market. Eventually, this will lead the Fed to lower the funds rate again, thus continuing the cycle.
How does the federal funds rate affect the money supply?
A lower fed funds rate will increase the money supply by encouraging more lending, borrowing, and business activity on the open market. A higher rate, on the other hand, discourages lending and decreases the money supply.