What is the federal funds rate? How the Fed sets interest rates, explained

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The Federal Reserve as we know it wouldn’t exist if not for interest rates.

Setting borrowing costs is how the Fed does its job: steering the world’s largest economy between the twin infernos of recession and overheating.

Cheaper rates lead the U.S. economy through (or in some cases away from) downturns by incentivizing consumers and firms to spend and invest. Hiking rates encourages a higher rate of savings, slowing the economy down and preventing a dangerous run up in inflation or price bubbles.

But how exactly the Fed makes sure interest rates fall in its desired target range is a tricky story. It’s not as if Fed officials set borrowing costs by going out and contacting every lender in the U.S.

Instead, the Fed has control over a benchmark rate that filters out through the rest of the economy known as the “federal funds rate,” or fed funds rate for short. But even then, consumers are bound to see some variation between the rate set by the Fed, and the rate they see on their credit card, savings account or certificate of deposit (CD).

Here’s how the fed funds rate works and how it impacts you — whether you’re a saver or a borrower.

What is the federal funds rate?

When you read headlines saying the Fed has hiked or cut interest rates, they mean the Fed has voted to adjust its key borrowing rate, the fed funds rate.

“The fed funds rate is the target for the rate banks pay to borrow from each other on an overnight basis,” says Greg McBride, CFA, Bankrate chief financial analyst.

It sounds complicated, but it’s simpler than you think. In normal times (meaning, when the U.S. economy isn’t in a recession or financial crisis), the Fed requires banks to maintain a minimum balance in their accounts at the Fed – just as you’re likely required to hold a certain amount of funds in your checking account.

Some banks have more funds than they need. Others don’t have enough to meet those nightly requirements. Banks then lend to each other.

One bank lends its extra cash to a second bank so it can meet those requirements, with the promise that those funds are paid back overnight. Of course, since no one wants to just lend freely, it comes with an interest rate. That’s where the fed funds rate comes in.

Officials normally adjust it incrementally by a quarter of a percentage point. But in more extreme circumstances, the Fed can modify it by a half a percentage point or more. The Fed reduced rates on March 15 by a full percentage point at an emergency meeting, an extraordinary attempt to soften the economic blow from the coronavirus pandemic.

Of course, banks can’t charge each other a “range.” They typically settle the interest rate at the midpoint of the Fed’s target, though it tends to fluctuate. Known as the “effective federal funds rate,” this rate is influenced by market factors while also guided by the Fed.

In the 1980s, the effective fed funds rate soared to as high as 19.10 percent, the highest it’s been, as officials worked to combat inflation. Back then, the fed funds rate was in a target range of 15-20 percent, a much wider band than is typical from the Fed.

The effective rate has now fallen to 0.05 percent as of April 2020, even lower than during the Great Recession of 2007-2009. Both during the coronavirus crisis and the Great Recession, the Fed set its rate in a target range of 0-0.25 percent.

In special circumstances, however, the fed funds rate can trade outside of that target range. In September 2019, a cash crunch in the market for repurchase agreements, or repos, led to the federal funds rate trading above its target range – at one point, as high as 10 percent in intraday trading. The Fed responded by intervening in the market and injecting cash.

But in other, less extreme cases, the Fed can solve that problem by adjusting another rate it controls: the interest on excess reserves (IOER) rate.

How the fed funds rate impacts borrowing costs

Most consumers care about the fed funds rate for one main reason: It influences how much they pay to borrow and how much they’re paid to save.

“It serves as a basis for the pricing of savings instruments, like savings accounts or CDs, and borrowing rates for consumers and businesses alike – everything from credit cards and home equity lines to small business loans,” McBride says.

But the IOER rate is perhaps the fed funds rate’s most important best friend.

Explaining why requires a trip back to the financial crisis of 2008. The Fed started paying banks interest on their reserve requirements and on their excess currency holdings, which came to be known as the IOER rate.

The IOER plays a key role in guiding interest rates throughout the financial system. And typically, when one falls or rises, the other does, too.

When the IOER rate is low, banks would prefer to lend those funds out, where they’d likely make a higher profit than keeping them in accounts at the Fed. That in turn lowers the cost of borrowing money in the economy because it increases the credit supply.

On the flip side, when the Fed raises the IOER rate, banks would prefer to keep more money at the Fed than lend to a potentially risky borrower. That increases the price of borrowing money because there’s less credit in circulation.

The Fed has been implementing policy in this way since the financial crisis of 2008, largely because banks have dramatically increased their currency holdings at the Fed. Before, the Fed would influence market rates by increasing the supply of banks’ reserves to balance out supply and demand. Extra cash in banks’ accounts would lower market rates. Less would increase interest rates.

“It’s a different means of accomplishing the same goal,” says Eric Sims, economics professor at the University of Notre Dame. “They want to change interest rates that are relevant to you and me, but they’re doing it in a different way now.”

How interest rates impact the economy

Understanding how this ultimately impacts the economy isn’t easy. The Fed’s work is mind-bogglingly complex.

If the U.S. economy were a car, the Fed would be one of its main drivers. Economic growth is the speed at which the vehicle is traveling – and interest rates are the foot pedals that give it more or less life.

It’s the driver’s job to give it enough speed to get it through the humps and hurdles, but not too much that it wrecks. Cheap borrowing costs give the U.S. economy more speed, propelling growth forward. But more expensive rates cause firms and consumers to pull back. That slows the economy down.

It’s easy to tell if the U.S. economy is in a downturn, mostly because unemployment tends to surge. But how does the Fed tell if the economy is running a bit too hot? By looking at inflation.

“Typically, interest rates and inflation go together,” says Gary Zimmerman, managing partner of Six Trees Capital and founder of MaxMyInterest.com. “In a period of high inflation, the Fed raises interest rates to slow down the economy.”

What interest rates are impacted by the federal funds rate?

Your wallet’s ultra sensitive to these rate moves. If it wasn’t, the economic impact would hardly work.

The Fed most notably has direct influence over CDs and savings accounts, and rates on auto loans, credit cards, adjustable-rate mortgages (ARMs) and home equity lines of credit. The Fed doesn’t directly impact mortgages – rather, the 10-year Treasury yield serves as the benchmark – but borrowers may notice that they’re influenced by similar patterns.

Federal student loan interest rates, meanwhile, are left up to Congress. Lawmakers also peg those rates to the 10-year yield.

The Fed also has a hand at influencing other benchmark rates throughout the economy. Most notably, that’s the prime rate, or the rate that banks charge their safest, most reliable borrowers.

The prime rate tends to hold at about 3 percentage points above the fed funds rate, and it goes on to affect rates on credit cards, HELOCs, auto loans and other types of loans you can get from a bank.

The London Interbank Offer Rate (Libor) – another benchmark rate – can also be indirectly influenced by the fed funds rate. Just as the fed funds rate is the overnight rate that U.S. banks charge each other, Libor is what international banks on the London interbank market are charged. That rate influences some student loan rates and adjustable-rate mortgages (ARMs).

Why market rates may differ from the fed funds rate

But there’s an important disclaimer: Market rates aren’t always going to hold where the fed funds rate is, even though they are influenced by them.

From a borrowing perspective, many lenders charge a margin on top of the benchmark rate. It’s mostly based on the riskiness of the borrower. Profitability can also be a factor.

“Borrowing rates reflect risk,” McBride says. “While the rate a bank pays to borrow overnight is near zero, even the federal government – which has the luxury of printing money to pay their debts – can’t borrow for free. If Uncle Sam, the ultimate risk-free borrower, is paying 1.2 percent to borrow for 30 years, you can bet it will cost a few percentage points more for a consumer taking a 30-year mortgage.”

When it comes to savings, yields differ from the fed funds rate because of the way the banking system is set up, Zimmerman says. Think of it this way: When you put money in an account at a bank, you’re essentially lending the bank money. And that loan has virtually no risk, as long as you’re depositing your money in an FDIC-insured bank.

“You’re not taking on the credit risk of the bank; you’re taking on the risk of the U.S. federal government because of FDIC insurance coverage,” Zimmerman says. “Banks don’t raise their rates simply because they don’t have to. They have sufficient deposits from their customers, and those deposits are very sticky because the majority of Americans don’t pay much attention to how much they’re earning.”

Bottom line

Even though broader market rates move in tandem with the fed funds rate, it’s always going to pay to shop around.

For savers, competitive rates are still out there, despite the fed funds rate holding at historically low levels for more than a decade. And for borrowers, you always want to make sure you’re choosing the right option for your financial situation, on top of the rate that you pay. That includes researching payment plans and the life of the loan.

“A lot of people are still accustomed to being a price taker rather than a price shopper,” Zimmerman says. “They have an existing bank and an existing relationship. They assume they’re powerless in this equation, but as the customer, you can shop around for the best rate. Much like you might pick the lowest interest rate for your mortgage, the best price for life insurance, you might also want to pick the best pricing and the highest rate for which bank you want to lend your money to as a depositor.”

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