What Is the Fed Funds Rate?

What Is the Fed Funds Rate?
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If you've followed news about the economy, you've likely heard about changes to the federal funds rate and wondered about what that means and how it impacts you as a saver, spender and borrower. The fed funds rate has to do with the interest rate that the Federal Reserve – the central bank for the United States – sets for credit unions and banks to use when they let other institutions borrow reserve funds through overnight loans. This rate will change based on various factors that impact the economy, and such changes can negatively or positively impact you depending on whether you're spending, saving or borrowing funds. So, it's important to learn about how the fed funds rate works, changes and affects you directly.

Federal Funds Rate Basics

To get a better understanding of the fed funds rate, it helps to first know the basics of how U.S. monetary policy works and the goals of the Federal Reserve. The Fed's goals for monetary policy include keeping the employment level high and ensuring that inflation stays under control as it will impact pricing and consumer buying power. These goals mean that the Fed has to take appropriate action in times of both economic trouble and prosperity. One way to help keep inflation under control involves adjusting the fed funds rate, and this will impact the interest rates that consumers get when they borrow or save money.

Keep in mind that the fed funds rate isn't the same interest rate that consumers get when they take out a loan or receive interest on their savings. Rather, this rate refers to what commercial banks and credit unions charge each other for overnight interbank loans of the money they have to keep in their reserves per the Fed's rules; these are collateral-free loans. The reserve funds are important so that banks have enough cash on hand to meet customers' needs and help avoid issues such as bank runs.

When the Fed decides to adjust the fed funds rate, it could simply make financial institutions keep a different amount of reserves on hand, but this doesn't happen too often. Instead, the Fed will usually change the amount of cash (government securities) it has on hand to lend to banks in order to impact the markets. For example, it can buy more securities to add cash or sell some off to reduce cash. Selling securities will lead to a higher fed funds rate due to less cash available on the market to lend, while buying securities will lower the rate as there's more cash available on the market for banks to lend.

Read More​: 7 Kinds of Interest Rates

Why the Rate Changes

The Federal Open Market Committee gets together ​eight times​ annually to discuss the economy and determine the fed funds rate target to set. It carefully pays attention to the unemployment rate and inflation when making such decisions and tries to find the best option to stabilize the economy. For example, if it sees strong economic growth, it might decide on a higher fed funds rate target. On the other hand, it might decide on a lower one when it looks like the economy is slowing down.

The reasoning for a fed fund rate decrease is that a lower rate can encourage consumers and businesses to borrow and spend more money, and this can boost the economy and increase inflation at the same time. On the other hand, a fed funds rate increase in times of high economic prosperity can encourage people and businesses to save more and spend less as borrowing becomes more expensive; this can help control excessive economic growth and reduce inflation. Such changes can occur in response to actual economic conditions at the time or perceptions of what could happen soon.

Example Feds Fund Rate Changes

If you're wondering about a recent situation where the fed funds rate dropped considerably, you can check the chart for earlier this year when the COVID-19 pandemic impacted the economy. You'll find that while the fed funds rate was ​1.25 percent​ on March 3, it dropped to ​0.25 percent​ on March 16. It has stayed at that same rate ​close to zero​ as of the most recent meeting on November 5. Prior to this, the fed funds rate had only actually dropped so low when the 2008 financial crisis had taken place.

On the other hand, you can look back at how the fed funds rate had kept rising from late 2015 through mid-2019 in response to low unemployment and inflation as the economy grew. For example, the fed funds rate started at ​0.5 percent​ in December 2015 and rose to ​1.25 percent​ by June 2017 and ​2.5 percent​ by December 2018. However, the Fed decided in August 2019 to lower the rate to ​2.25 percent​, and it would fall to ​1.75 percent​ by October 2019 in response to concerns about the economy starting to slow down.

Implications for Borrowers

Although the fed funds rate isn't the same short-term interest rate you'd pay on a credit card or car loan, changes will impact the cost of borrowing. This is because creditors and banks will use the prime rate as part of determining your interest rate as a borrower, and the prime rate typically is estimated to be ​fed fund rate plus three percent​. Of course, your creditor or bank can add more percentage points depending on the product and risk involved in lending to you, so don't assume you'll get a loan or credit card with a super low interest rate.

However, you could benefit from lower rates for new credit cards, mortgages, auto loans, home equity loans and personal loans when the fed funds rate drops, while rates for these financial products rise when the fed funds rate does. That means that it could be a good time to make a major purchase or refinance an existing mortgage to benefit from lower rates, but there can also be negative impacts like lower credit limits and more challenging approval requirements during such times. If you have an adjustable-rate loan, though, a fed funds rate increase can hurt you with a higher interest rate.

Implications for Savers

Fed funds rate changes will have the opposite effect on you as a saver versus a borrower.

Rate drops will hurt you since you will get a lower return on your savings, and this can motivate you not to save as much as you usually do. The exception is if you're locked into a specific interest rate such as with a fixed-rate certificate of deposit.

On the other hand, fed funds rate increases will help you as a saver since you should see your interest rate rise as long as you've got an adjustable-rate product like a traditional savings account or money market account. So, you might feel motivated to stash away more money.

Implications for Spenders

You might also notice the impact of fed funds rate changes as a spender when you purchase everyday items. That's because such adjustments can alter your purchasing power per dollar. This can be for better or for worse.

A fed funds rate decrease due to a sluggish economy when people can't afford to buy as much will help cut inflation and stabilize prices. On the other hand, a fed funds rate increase during a strong economy will raise prices and inflation when people are buying more items. In either case, you can see a direct impact on your wallet that may encourage or discourage you to spend as much as you normally do.

Consider keeping an eye on the fed funds rate so that you know the latest on how it's going to impact your buying, saving and borrowing decisions.