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What’s the Fed Rate and what does it mean for you?

Even if you don’t regularly monitor financial news, you’ve probably often heard the terms “the Fed” and “the Fed Funds Rate” being used widely or making headlines. But despite their prevalence, you may be wondering, what do they mean for you and your money?

The Federal Reserve is the central banking system of the U.S., and is often simply referred to as the Fed. The Federal Funds Rate is one of the main tools the Fed uses to guide monetary policy.

Even if seems far removed from your day-to-day, it’s important to keep in mind that the Fed Funds Rate can impact a wide range of common financial transactions, including how much you earn on savings, the rate you pay on credit card balances, and whether or not you can get a home mortgage, car loan, or personal loan. Essentially, the cost of money in the U.S. economy is directly tied to the Fed Funds Rate.

Understanding the Fed Funds Rate and how it impacts banking, borrowing, and saving can be a useful tool for financial planning. Here, we’ll dive into how the Fed Funds Rate is determined and what they mean for you as a consumer.

What is the Federal Reserve?

Congress created the Federal Reserve System in 1913 to be a central bank for the United States in response to financial crises of the early 20th century. The Fed is made up of 12 banks, each responsible for a regional division of the country.

The board of governors and Federal Open Market Committee make decisions for the Fed. The responsibilities of the Federal Reserve include the following.

  • Oversee national monetary policy:

    This includes things like determining credit conditions in our economy to manage employment and keep pricing and interest rates steady.

  • Direct and regulate banking institutions:

    This allows the Fed to make sure U.S. banks are safe and protect American consumers.

  • Ensure financial system stability:

    One of the Fed’s main responsibilities is managing inflation, or the devaluation of currency over time.

  • Administer financial services:

    This includes providing support for the national payments system and the U.S. government.

What is the Fed Funds Rate?

The Fed has a rule that banks must keep enough cash on hand to open for business every day. This rule is designed to ensure banks can run steadily and don't hand out every dollar in their vault. However, the banks do not earn interest on this money. As a result, the banks often try to stay as close as possible to the reserve limit without going beneath it, which prompts them to lend money between each other.

If a bank is low on cash, they can borrow from another bank. When a bank lends money to another bank, the borrower is charged the Fed Funds Rate for the loan. That means the Fed Funds Rate is the average interest rate that banks pay for overnight borrowing in the federal funds market.

Why does the Fed Funds Rate exist?

The Fed Funds Rate plays into how federal funds are used to control the nation's interest rates. By requiring banks to have cash on hand, the Fed ensures that customers can always get money from their banks.

The goal is to keep inflation low, and to do that the Fed raises the Fed Funds Rate. Inflation means the dollar is worth less. If inflation rises unexpectedly, basic needs (housing, food, utilities) suddenly become more expensive and the economy suffers.

Keeping the inflation rate low and stable means people can reliably buy what they need and the economy, in theory, stays healthy.

What does this mean for me, as a consumer?

The Fed Funds Rate sets the bar for credit rates. So, what does that translate to for you as a consumer?

That means the borrowing rates you can get on your credit cards, mortgages, and other loans are, to a degree, based off of the Fed Funds Rate. Buying a car or a home or taking out a personal loan can be more expensive because you’ll be paying more in interest. And if you want to refinance your mortgage or student loans, higher rates can make doing so more expensive.

It also means that interest rates can go up on credit cards, which can increase your debt if you’re carrying an outstanding balance.

When interest rates go up, money is more expensive to borrow, which can also impact the often volatile stock market and cause stock prices to slide. When the Fed cuts rates, the stock market generally goes higher given that the cost of borrowing goes down, which translates to a greater ability for companies to expand their businesses.

On the flip side, when rates rise and borrowing gets more expensive, equity markets can struggle and stock prices can go down. More cautious investors may move their money out of riskier investments into more conservative ones like government bonds.

Given that many retirement plans are invested in the stock market, this can have serious ramifications. And, as the Federal Funds Rate goes up or down, it can also affect the interest rate of the money in your retirement plan.

What are low and high Fed Funds Rates?

In times of crisis, such as during the COVID-19 pandemic, the Federal Reserve lowers the target for the Federal Funds Rate. Money is freed up and easier to borrow when Americans have less to spend.

In June 2020, the Fed Funds Rate was 0.25% (up from nearly 0% earlier in the pandemic). The last time the fed rate was this low was during the 2008 financial crisis, and the Great Depression in the 1930s before that.

In 1980, the Fed Fund Rate was at a high of 20%, which was in response to double digit inflation. As of February 2023, the Federal Funds Rate is at 4.50% to 4.75%, which is the highest it’s been since the 2008 financial crisis.

Does this affect savings accounts?

Changes to the Fed Fund Rate have downstream effects on financial products like high-yield savings accounts. Banks and other financial institutions are more prone to pay greater interest on high-yield savings accounts to stay competitive and seem more attractive to consumers looking to make deposits.

While the Fed Funds Rate is complicated, the effects most people will notice are more straightforward. Even small changes to the Fed Funds Rate can have an impact on the financial system as a whole, and thus, you as a consumer.

By causing interest rates to increase or decrease, especially on loans with variable interest rates, the Federal Funds Rate plays a significant role in every consumer’s life, whether they like it or not. Even if the influence isn’t felt directly, it will most likely impact some area of your finances at some point, which is why it can be important to understand the basics.

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