The federal funds rate is a target interest rate that guides lending between U.S. banks over night. This rate, in turn, affects the interest rates customers are charged to borrow money and paid for saving money.
The Federal Open Market Committee – a division within the Federal Reserve – determines the federal funds rate. This committee comprises up to 12 voting members who hold eight meetings annually to review the economic and financial health of the U.S. in addition to monetary policy. The FOMC’s goal is to keep the economy in shape by stabilizing prices and maximizing employment.
How Federal Funds Rate Works
If you’ve ever wondered how banks get money to provide customers loans and other lines of credit, it comes from the cash you deposit into financial accounts. To ensure stability, regulators require financial institutions to have a minimum amount in their reserves. It’s similar to how some banks require you to have a minimum balance in your checking account to avoid fees.
To ensure banks meet their reserve requirements, they often borrow funds from banks who have excess cash. The federal funds rate determines how much banks can charge for these short-term loans.
Federal fund rates don’t only affect the interest rate at which banks borrow money between themselves. They also affect the interest rates they charge customers and can have positive effects on the cost of saving.
The Fed Funds Rate And The Economy
When the Fed raises interest rates, it’s usually in attempts to reduce inflation. The hope is that by raising interest rates, the cost of borrowing goes up, spending stalls, and there’s less money flowing through the economy.
When interest rates are high-such as on mortgages or car loans for instance-people are likely to spend less. In an ideal scenario, prices of goods and services would fall and the economy would stabilize.
Just as Fed rates go up, they can also come down. When the Fed reduces interest rates, it’s usually to boost the economy when things are slow. Dropping interest rates makes borrowing more affordable, encourages spending and in a best case scenario, results in economic growth. A recent example was in 2020 during COVID-19 when the Fed dropped interest rates to 0%-0.25% to protect the slowing economy.
Employment
As we’ve established, higher rates set by the Fed often lead to expensive borrowing. This can affect companies’ willingness to take out loans, leading to decreased spending and investment. What does this mean for the labor market? Spending less and investing less can lead to reduced demand for workers and higher unemployment.
Borrowing and saving
Borrowing money becomes more expensive when federal fund rates are high. Examples include a hike in interest rates on car loans, higher interest rates on credit card debt, and higher rates on adjustable-rate mortgages. On the flip side, the interest rate on your high-yield savings account is likely to go up, when interest rates go up, meaning you get paid more compound interest for saving. The same applies to certificates of deposit also known as CDs.
Stock market
When interest rates increase and the economy slows down, that can impact the stock market too. A slower economy can mean less growth for companies, a decline in their earnings, and a slump in stock prices. Since debt is more expensive when interest rates go up, companies may also find more of their revenue going to paying down debt, which can negatively affect their earnings.
Investors, especially those who are risk averse, may take a backseat on stock investments and turn to lower risk alternatives like bonds. They tend to perform better than stock when the economy is down or experiencing a recession.
Risk-Free Rate and Fed Funds Rate
When an investment carries zero risk, the rate of return is known as the risk free rate. This rate is typically used when it comes to short-term government debt like bonds. Since the government has never defaulted on its debt, the rate of return is considered ‘risk free’. Treasury bills, also known as t-bills are also considered an investment with a risk free rate.
When federal fund rates are high, investments with a risk-free rate can be attractive to investors. They’re also a good way to balance and diversify stock heavy portfolios, which tend to be vulnerable to market volatility.
If you’re interested in diversifying your portfolio through investments with risk-free rates, speak to one of our financial planners today.
