What Is the Federal Reserve and the Fed Funds Rate?

If you follow the economy (or even just scroll your favorite social app), you’ve probably at the least heard about the Federal Reserve. And lately, there's been plenty of buzz about interest rate changes and their impact on inflation.

Here’s your quick guide to the Federal Reserve, the Fed rate, and how these changes affect your wallet and financial decisions.

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What Is the Federal Reserve?

The Federal Reserve, also known as “the Fed,” is the central bank of the United States. 

The title of “central bank” is a big one, and it comes with major responsibility. This includes managing the country’s money supply, controlling interest rates, and regulating banks. 

The Fed also seeks to maintain economic stability and foster a healthy economy. 

Perhaps one of the Fed’s most notable duties includes keeping inflation low, maximizing employment, and ensuring that the financial system runs smoothly. 

What Is the Fed Funds Rate?

The Federal funds rate (or “Fed rate”) is the interest rate that banks pay when they borrow money from each other. This is done to make sure they have enough cash on hand and usually happens overnight. 

Banks are required by law to keep a certain amount of their customer's money on hand (or “reserve”). This money isn’t eligible to earn interest. So, banks shoot to stay as close to that reserve limit as possible and lend money (and receive money) to stay at that limit.

The Federal Open Market Committee (FOMC) sets the Fed funds rate to help control the economy. 

When they raise the rate, borrowing becomes more expensive, which can slow down spending and theoretically help reduce inflation.

On the flip side, lowering the rate makes borrowing cheaper, which encourages spending and can boost the economy.

What the Fed Funds Rate Means for You

The Fed’s decisions influence everything from loan rates to job growth across the nation. And the Fed funds rate directly influences your finances.

The Fed funds rate is the baseline rate for banks to set their own rates. That record-breaking high-yield savings rate you have? It’s likely tied to the Fed funds rate. That super-low mortgage rate you obtained during COVID times? Also thanks to the Fed funds rate.

A drop in the Fed funds rate will lower how much APY you earn on deposits, like in your savings account or on certificates of deposit. But a drop in the Fed funds rate also lowers how much interest you have to pay for borrowing money.

The Fed funds rate also has an impact on housing demand and the stock market, thus affecting you if you are in the market for a new home or have an investment account.

RELATED: Should You Pay Off Debt or Invest?

What happens when the Fed lowers the Fed rate?

A drop in the Fed rate means borrowing is cheaper. Interest rates on mortgage loans and consumer loans like car loans will be lower. 

In general, lower borrowing costs increase consumer spending and business investments and stimulate economic activity.

However, banks also drop rates on their savings and deposit accounts since they aren’t being paid as much on the money they cycle through the system. This encourages people to invest in higher-yielding options like the stock market.

Another general rule of thumb is that a lower Fed rate often weakens the U.S. dollar, which makes American goods more affordable abroad. 

Lowering the Fed rate is about striking the right balance though, as lowering the rate too much can lead to inflation if demand grows too quickly. 

RELATED: What Is a Bull Market?

What happens when the Fed increases the Fed rate?

When the Federal funds rate increases, borrowing becomes more expensive. This means you will see higher rates on mortgage loans, car loans, and even on your credit cards. 

Because it’s more expensive to borrow, consumer spending and business investments can slow down, causing an economic cool-off. 

Higher rates usually strengthen the U.S. dollar and make imports cheaper while the exports will be more costly abroad. Therefore, this can reduce international demand for American goods. 

The best thing about higher Fed funds rates though is you will get better returns on savings accounts and other low-risk investments.

The decision to raise rates is typically used to combat inflation, as it reduces demand-driven price pressures. But, just like with lowering the Fed rate, if rates are too high for too long, it can risk causing a recession.

RELATED: What Is a Bear Market?

FAQs

How does the Fed determine the Federal funds rate?

The FOMC sets the federal funds rate by looking at economic data. Inflation and employment are the two major factors. The Fed’s goal is to keep prices stable and maximize employment. 

So, if inflation is high, the Fed may choose to raise rates to cool the economy. If economic growth slows, it may lower rates to boost activity.

How often does the Fed adjust the Fed rate?

The Federal Reserve can choose to adjust the federal funds rate at any of the scheduled FOMC meetings. Usually, they meet eight times a year. The Fed may choose to make any rate changes or make rate cuts or increases at any of their meetings.

The Fed can also change the rate outside of the meetings if there are unexpected economic changes or national emergencies.

TL;DR: The Fed Funds Rate and Your Money

The Federal Reserve is the key player in the U.S. banking system, and its decisions are a major driver of economic growth or a recession. 

Meanwhile, the Fed funds rate is a key player in your everyday finances, from borrowing to saving. Keep an eye on rate changes when making important financial decisions. 

For tips on managing your money no matter the current economy, check out these episodes of the Erika Taught Me podcast:

• How To Invest for Beginners (Step by Step)
• How To Become Better With Money
• 10 Steps Towards Financial Wholeness

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