The Federal Reserve System (or just “the Fed”) is America's central banking system. As dictated by Congress, the Fed has three main tasks: stabilize prices for Americans, create conditions that maximize employment rates, and moderate long-term interest rates. While the Fed has several tools and mechanisms to achieve these objectives, the one you probably hear about most is the fed funds rate. This is what news anchors are talking about when the say, “The Fed has raised interest rates again this year.”
But what does all of it mean? And how does it affect you?
How the fed funds rate works
The Fed requires that financial institutions hold a certain amount of capital in reserve at the end of every day, determined as a percentage of the total loans the bank or credit union has made. This reserve requirement prevents banks and credit unions from lending out every single dollar and not having enough cash on hand to start the next day.
At the end of every day, some financial institutions don’t have enough in reserve to meet the requirement, while others have much more than they need. To solve this problem, those with more than enough money in reserve will lend their extra Federal Reserve funds overnight to those that need it. The fed funds rate is the interest rate the banks and credit unions charge each other for this type of loan.
Why the Fed changes the rate
The Fed will adjust the fed funds rate to effect changes in the American economy. To boost economic growth, the Fed will lower rates, which makes borrowing money cheaper for banking entities, who pass down this saving to their customers, encouraging consumers to borrow money (take out loans, charge purchases to their credit cards) and increase spending.
The Fed can also increase rates to slow borrowing and spending. They often do this in response to growing inflation in the economy, when people are spending so much that prices are skyrocketing, and the economy is “overheating.”
Regardless of which direction the fed funds rates are changed, it takes about 12 to 18 months for the change to affect the greater economy.
How raising the rate affects you
The higher the fed funds rate, the less likely banking institutions are to borrow money to keep their reserves at the required levels (because they don’t want to pay the higher interest rate for borrowing that money). If a bank wants to avoid having to borrow extra Federal Reserve funds at the higher rate from another bank, they will lend less money out to consumers. The money they do lend out will be at a higher interest rate.
After a fed funds rate increase, banks will first raise interest rates for their business clients—known as the “prime rate”—usually within a few days of the Fed’s announcement. Because loans are now more expensive for them, corporations will be less likely to borrow and grow their business, which means employees are less likely to see bonuses and large pay raises.
Because adjustable-rate (also called variable-rate) loans like certain mortgages, home-equity lines of credit, some private student loans, and credit-card rates are benchmarked against the prime rate, they are the next to be affected by the increased rate, typically within 60 days of the change. Homebuyers will now only be able to afford smaller loans, slowing the housing industry.
At the same time, the price of other goods like food and gasoline will stay low, and each paycheck should stretch further as inflation is slowed. Rising rates will also benefit those who have money in high-yield savings accounts.
How lowering the rate affects you
When the Fed lowers the rate, the opposite occurs: banking institutions are more likely to borrow from one another, businesses expand, salaries increase, credit card rates drop, larger mortgages are lent out, and consumers spend more. The economy is stimulated and allowed to grow until the balance is tipped once more with overspending and inflation, which will prompt the Fed to once again raise rates.