Federal funds rate: What it is and how it affects you
12 Mar 2024
The federal funds rate. The Fed. The FOMC. All these terms we hear in the news that somehow deal with interest rates. What does it all mean?
Here's what you need to know about the federal funds rate — and why it matters. We'll keep it really simple.
What is the federal funds rate?
The federal funds rate is the interest rate the government sets for one bank to charge another bank for ultra-short-term loans, usually just overnight. It's actually an interest rate range. Banks negotiate a specific rate between each other within that range set by the Federal Reserve.
That's it.
The current federal funds rate is 5.25% to 5.50%.
But here's some flavor for you monetary trivia fans.
The federal government used to require banks to hold a certain percentage of their deposits in cash as a reserve. That ended in 2020.
When banks were required to have reserves, those funds were held in the U.S. Federal Reserve System, often called "the central bank," or just "the Fed." There are 12 Federal Reserve banks across the nation.
Today, banks still hold money at the Fed, but for a different reason: to manage the flow of enormous sums of cash day to day. For example, when a bank moves a great deal of money and needs some extra liquidity, it can borrow the cash from another financial institution through the Federal Reserve System.
Now, here's why all of this matters to those of us who aren't bankers.
Who decides the federal funds rate?
The U.S. central bank — the Federal Reserve — has a committee that meets eight times a year to set the interest rate range that banks will use to borrow from each other. It's called the Federal Open Market Committee.
At these meetings, the FOMC decides whether to raise, lower, or keep that interest rate the same. CNBC, Bloomberg, and, yes, Yahoo Finance are all over this news. "The Fed raises rates by a quarter point!" Or, "FOMC cuts rates!"
Those are the headlines you'll likely see. Maybe without the exclamation points.
Why does the Fed adjust the federal funds rate?
The Fed makes these interest rate changes to adjust the economy and manage consumer costs. Higher prices on groceries, gas, and most everything else is called inflation.
By raising interest rates, the Fed makes borrowing money more expensive. As a result, the economy is expected to slow, and with it, inflation will ease.
If the economy needs a boost, the Fed lowers interest rates.
How does the federal funds rate affect me?
Those interest rate changes at the very top rung of the financial pyramid trickle all the way down through the banking industry. Since banks pay interest to borrow from each other, they use that baseline cost to set their interest rates for consumers.
Everything is impacted:
Interest paid on savings accounts
Interest paid on high-yield savings accounts
Interest paid on certificates of deposit
Interest charged on credit cards
Interest charged on loans
The federal funds rate does not directly impact mortgage rates, but Fed interest rate moves do influence Treasury bonds and the bond market as a whole. So, a rising or falling fed funds rate will give you an idea of how home loan rates will likely move.
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