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Federal Funds Rate: How the Fed Impacts Interest Rates
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Several times a year, you may hear that the Federal Reserve is considering raising or lowering interest rates. What exactly does that mean?
It’s worth knowing, because, whether you realize it or not, you do have a stake in what the Fed does. After all, you probably interact with interest rates in a variety of ways, through your credit cards, mortgage, car loans and bank accounts. Plus, since the Fed’s actions have broader impacts on the economy than just affecting interest rates, Fed policy could play a role in everything from your job security to the prices you pay at the supermarket.
So, to understand how the actions of the Fed might affect you and the financial decisions you make, it is helpful to know something about the Federal Funds Rate, how and why it is changed, and what impact it has on the economy.
What is the Federal Funds Rate?
The federal funds rate is a target interest rate for short-term, government securities. This rate is crucial to the economy because it determines the cost at which capital is available to the banking system.
The federal funds rate is important because it determines how expensive it is for banks to access the capital they use to make loans. If the federal funds rate is high, it’s more expensive for banks to access capital so they are less likely to make loans. Plus, the loans they do make are going to have to charge high interest rates to make up for the higher costs being incurred. This, in turn, means higher costs for consumers and businesses.
In a nutshell, that’s why everyone gets freaked out when the Fed looks like they’re going to raise rates — a higher-interest federal funds rate can make lending more expensive for banks, businesses and borrowers alike, thus dampening economic activity.
The other side of the coin is that lower interest rates encourage borrowing, and thus tend to fuel economic activity. Depending on how the economy is behaving generally, it is useful to be able to tap the brakes occasionally by raising the federal funds rate to slow activity down. Likewise, there’s benefit to being able to step on the gas now and again by lowering that rate. (This occurred in response to the 2008 financial crisis.)
Obviously then, adjusting the federal funds rate is a vital job. Who gets to make that decision, and what drives those decisions?
Meet the Federal Open Market Committee.
The Federal Open Market Committee (FOMC)
The Federal Reserve was created in 1913 with responsibility for setting monetary policy, and today consists of a central Board of Governors plus 12 regional Federal Reserve Banks. The Federal Open Market Committee, or FOMC, is a subset of the Federal Reserve and consists of the Board of Governors, the head of the New York Federal Reserve bank, plus four of the other 11 regional Federal Reserve bank presidents who participate in the FOMC on a rotating basis.
Each member of the Board of Governors is nominated by the president and confirmed by the Senate. From this group, a chair and vice chair are also nominated by the president and confirmed by the Senate. One of the chair’s duties is to coordinate the activities of the FOMC, though each member of that committee gets to vote on its decisions.
The FOMC typically meets eight times a year — about every six weeks or so, according to the Fed website. Its mission, as defined by Congress, is to strike a balance among three goals: encouraging employment, keeping inflation under control and smoothing out swings in long-term interest rates. The challenge is that these goals can sometimes be in conflict with one another.
As described previously, lowering interest rates is like stepping on the economy’s gas pedal.
But wait: Since a growing economy is so clearly a good thing, why not just keep interest rates low all the time?
The answer, in a word: Inflation. Low interest rates can also fuel inflation, making it difficult for ordinary people to afford everything from groceries to housing. Inflation also creates an element of unpredictability that makes it harder for businesses to make long-term strategy decisions.
This is why using the federal funds rate to both encourage employment and control inflation can be a delicate balance.
How do federal funds rates work?
How exactly does the FOMC adjust interest rates?
Short-term lending rates
Though the average person may not realize it, the banking system runs on huge amounts of short-term loans between the government and institutions, and between the institutions themselves. This helps ensure money is available where and when needed. These loans are made by issuing very short-term interest-bearing securities.
If the FOMC wants to lower interest rates, it buys an unusually large amount of those securities, driving their prices higher and making their interest rates lower.
Selling short-term securities has the opposite effect. The Fed sets a target range for short-term rates, and buys or sells securities on the open market until rates have adjusted to that range.
Longer-term security purchases
Traditionally, the FOMC had been primarily focused on short-term interest rates, but in response to the housing crisis that began in 2008, the FOMC adopted additional policy measures in order to more directly affect long-term rates, like those of mortgages. It did this by buying trillions of dollars of long-term Treasury and mortgage-backed securities.
That buying demand in long-term income markets drove the prices of those securities up and their yields down. This activity played a key role in pushing 30-year mortgage rates down from 6.48 percent in August of 2008 to a record low of 3.35 percent by November of 2012.
Impact on consumer interest rates
While the goal of the FOMC is to use federal funds rates to nudge the economy in the right direction from time to time, this is not an exact science. There are, after all, many other factors that also impact the economy. Plus, from a consumer’s point of view, the FOMC is affecting the economy indirectly — not by dictating the interest rates that consumers pay or receive, but rather by trying to influence those rates by affecting the cost at which capital is available to banks.
This is why you may hear about an increase or decrease in the federal funds rate, and not see any immediate impact on the interest rates that you deal with directly. During 2008, the FOMC lowered the federal funds rate by around four percentage points, down to nearly zero. Subsequently, the FOMC raised the federal funds rate by a percentage point from 2015 through late 2017. The following is a look at how some consumer interest rates reacted during these upward and downward moves in the federal funds rate.
Deposit accounts (checking, savings, CDs, etc.)
- When rates go up… deposit account rates go up.
- When rates go down…deposit account rates go down.
The FDIC tracks national average rates on deposit accounts, but this history only goes back to May of 2009. Still, even this limited history is enough to provide some insight into how rates on savings accounts and other deposits react to federal funds rate changes.
By May of 2009, deposit rates were already down to 0.22 percent in the wake of the series of 2008 FOMC rate reductions, and they subsequently fell all the way down to 0.06 percent.
Significantly though, since the FOMC turned in the opposite direction and started to nudge rates up, banks have been slow to respond by raising the rates they offer consumers on savings accounts and other deposits.
When the federal funds rate is falling, banks are quick to drop the rate they offer to customers accordingly. When the federal funds rate starts to rise though, banks feel no urgency about paying more to their customers until consumer demand forces them to.
- When federal funds rates go up: mortgage rates may go up, especially if the FOMC is responding to accelerating inflation.
- When federal funds rates go down: mortgage rates may go down, especially if the FOMC also employs strategies targeting long-term rates.
As noted earlier, in the wake of the housing market collapse and the Great Recession, the FOMC employed a newer tactic of investing heavily in long-term income securities in an attempt to drive mortgage rates down. The impact was dramatic.
During the FOMC’s purchase program, from November 2008 through October 2014, 30-year mortgage rates fell by more than 2 percentage points. Since then, the FOMC has stopped increasing its holdings of long-term income securities, but it has not yet heavily liquidated those holdings, and 30-year mortgage rates have stayed in a range between 3.44 and 4.20 percent.
The takeaway here seems to be that the FOMC can affect mortgage rates, but it depends which tactic it uses. Also, keep in mind that when committing to lend money for 15- or 30-year periods, lenders have to anticipate economic factors other than Fed policy, such as inflation.
- When federal funds rates go up: credit card rates go up if inflation is accelerating, otherwise they may be relatively unaffected.
- When federal funds rates go down: credit card rates may not follow suit due to rising credit concerns.
While most interest rates have fallen sharply since the Great Recession began at the start of 2008, as of late 2017 credit card rates were actually higher than they were at the end of 2007. They have had their ups and downs in the meantime, but overall seem somewhat indifferent to Fed rate policies.
Why is that? Well, the FOMC often lowers interest rates during recessions or other times when the economy seems to be in trouble. Unlike mortgages, credit card debt is usually not secured by collateral, so credit card companies have to be especially sensitive to credit risk. When the economy is struggling, the federal funds rate may be going down but the risk of credit card customers not paying their bills goes up.
This creates a conflict for credit card companies, between lowering rates in response to the federal funds rate and raising their rates to cover heightened credit risk. This conflict helps explain why credit card rates seem less directly responsive to federal funds rate changes.
Put another way: When it comes to the plastic in your wallet, even when you hear about the FOMC lowering rates, don’t be surprised if your rates stubbornly stay right where they are — or if they actually move in the opposite direction.
- When federal funds rates go up: loan rates generally may rise, especially if the FOMC is responding to accelerating inflation.
- When federal funds rates go down: loan rates may also fall as long as credit concerns are not rising dramatically.
Car loans and other personal loans can be thought of as falling somewhere between credit card debt and mortgages. Their repayment periods are longer than for credit cards but shorter than for mortgages. Unlike credit cards, these loans typically have some form of collateral, but the nature of that collateral is not likely to be as reliable as, well, a house.
Overall, car loan and personal loan rates have reacted more like mortgage rates than credit card rates since the start of the Great Recession. From the end of 2007 through the third quarter of 2017, car loan rates have fallen by a few percentage points. Personal loan rates fell to 9.76 percent, on average, from 12.16 percent at the end of 2007
So, if you hear the federal funds rate is falling, it may be good news in terms of the rate you can get on a car or personal loan. But be advised: Your credit rating will also play a big role.
How the federal funds rate affects the economy
Federal funds rates and other tools are used by the FOMC to try to balance the goal of helping the job market against efforts to keep inflation in check. Beyond employment and inflation though, FOMC decisions can have other impacts of great importance to you, especially when it comes to home prices and investments.
Since the collapse of the housing market was widely viewed as a root cause for the Great Recession, the FOMC tried to address this by driving mortgage rates down. The move seems to have worked. According to the S&P CoreLogic Case-Shiller National Home Price Index, though home prices fell by 27.4 percent from July of 2006 through February of 2012, they have since responded by bouncing back beyond their pre-collapse level.
Besides home prices, FOMC policy also has an influence on the value of stocks and bonds. By buying income securities — especially by buying long-term securities in the wake of the Great Recession — Fed policy boosts the value of bonds. Also, lower rates are generally welcomed by the stock market. Why is that? Well, partly it’s because investors are encouraged to seek investments like stock when bond yields are very low. Also, because policies to stimulate the economy should ultimately benefit the companies that depend on that economy.
Since the Great Recession, the stock market has had a best-of-both world’s scenario: The economy has recovered with an unusually long expansion, while the FOMC has not yet raised interest rates to anywhere near their pre-recession levels. During this time, the S&P 500 has risen by nearly 180 percent.
While there are clear benefits to lowering interest rates, the FOMC feels obligated to raise rates at times to keep inflation in check. Also, to make sure it has room to lower rates the next time economic growth is threatened.
The table in the next section can give you a feel for how the FOMC has juggled its goals of nurturing growth and controlling inflation over time.
Federal funds rates and the economy: Some history
The table below shows a half-century of year-by-year percentage history for federal funds rates, unemployment and inflation. (CPI equals Consumer Price Index). The red-colored years in the federal funds rates column indicate recessions.
It can be difficult to properly digest several years of economic data at once, but here are some of the major points to look for on this chart:
- The federal funds rate has typically risen over the course of economic expansions (the green periods) while it has tended to fall during or immediately after recessions (the red periods).
- The following periods show examples of how the FOMC responded to higher unemployment by lowering the federal funds rate: 1971-1972, 1975-1976, 1991-1993, 2001-2003, 2008-2009.
- In contrast, the response to high unemployment in the early 1980s was complicated by the fact that the FOMC was obligated to keep rates high due to unusually high inflation.
|Historic Federal Funds Rates (1967 – 2016)|
|Year||Federal funds effective rate||Year-end unemployment rate||Year-over-year change in CPI|
The federal funds rate has an important influence on the economy in general, including interest rates that affect you, the consumer, just about every day. However, that influence is not as simple as flipping a switch and seeing consumer interest rates rise and fall. And yes, those rates are affected by a number of other factors besides the federal funds rate, particularly credit risk and inflation.
FOMC decisions are both an important influence on economic conditions and a reflection of those conditions. Consequently, those decisions are worth paying attention to for insight into how recent developments might impact your financial and career decisions.