If you pay attention to the news, you have probably noticed that the Fed makes headlines every so often—and it usually dovetails with other major events. In response to a stock market spiraling in the face of COVID-19 in 2020, the Fed cut its interest rates swiftly and seriously, to between 0.0% and 0.25%. As of April 2021, the current federal interest rate—otherwise known as the federal funds rate—remains between 0.0% and 0.25%.
There’s a connection between the Fed’s rates and the national economy, as well as your personal finances. The Fed works to help balance the economy over time—and its actions and influence on monetary policy can have an effect on individual wallets.
Here’s what consumers should know about the Federal Reserve interest rate, and how it trickles down to the level of individual wallets.
How Does the Fed Influence the Economy?
“The Fed” is short for the Federal Reserve System, which is the central US bank. The Fed is the main regulator of the US banking system and is made up of a dozen smaller banks, each of which is localized to a specific geographical region in the country.
Along with setting its target interest rate, the Fed also has other financial duties and powers—more so than regular banks—to take measures to ensure systemic financial stability. These duties include:
• Supervising and regulating smaller banks
• Conducting and implementing national financial policies
• Maintaining widespread financial stability, in part by setting interest rates
• Providing financial services like operating the national payments system
The Fed has authority over other US banking institutions and can regulate them in order to protect consumers’ financial rights. But perhaps its most famous job is setting its interest rate, otherwise known as the federal funds rate.
The federal funds rate, or federal interest rate, is a target interest rate that’s assessed on the bank-to-bank level. It’s the rate at which banks charge each other for loans borrowed or lent on an overnight basis.
The federal funds rate is not directly connected to consumer interest rates, like those that might be paid on a personal loan or home loan. But it can have a major influence on those interest rates, and over time has the ability to impact how both businesses and individuals access lines of credit.
Recommended: The Federal Reserve Cheat Sheet
How Is the Federal Funds Rate Set?
The federal funds rate is set by the Federal Open Market Committee (FOMC), at a minimum of eight times per year—though the committee will meet more often than that if deemed necessary.
Federal funds rate adjustments are decided based on key economic indicators that may show signs of inflation, recession, or other issues that may impact economic growth.
Current Federal Funds Rate
The federal funds rate is a recommended target—banks can ultimately negotiate their own rate when borrowing and lending from one another. Over the years, targets have varied widely depending on the economic outlook—as high as 20% in the early 80s (due to inflation), and as low as 0.0% to 0.25% in 2020 as a response to the COVID-19 pandemic, where it remains as of April 2021.
How Does the Federal Funds Rate Affect Interest Rates?
Although the federal funds rate doesn’t have a direct influence on the interest levels for loans taken out by consumers, it can change the dynamics of the economy as a whole through a kind of trickle-down effect.
The Fed often slashes rates as a response to turmoil in the market as an attempt to boost the economy. Lower rates may make it easier for businesses and individuals to take out loans and thus create more cash flow.
On the other hand, the Fed may raise interest rates when the economy is strong in order to keep borrowing (and inflation) in check, which can help prevent the kind of bubbles that can lead to crises like we saw in 2008.
The Fed’s rate changes have an impact across a broad swath of financial areas—from credit cards to mortgages, from savings rates to life insurance policies. The Fed’s rate change can affect individual consumers in a variety of specific ways.
The Prime Rate
A change to the federal funds rate can influence the prime interest rate (also known as the Bank Prime Loan Rate ). The prime interest rate is the interest rate banks offer their most creditworthy customers when they’re looking to take out a line of credit or a loan.
While each bank is responsible for setting its own prime interest rate, many banks choose to set theirs based in large part on the federal funds rate.
Generally, the rate is set approximately three percentage points higher than the federal funds rate—so, for example, if the rate is at 0.25%, a bank’s prime interest rate might be 3.25%.
Even for consumers who don’t have excellent credit, the prime interest rate is an important figure. It’s the baseline from which all of a bank’s loan tiers are calculated.
That applies to a wide range of financial products, including mortgages, credit cards, automobile loans, and personal loans. It can also have an effect on existing lines of credit that have variable interest rates.
Savings Accounts and Certificates of Deposit
Interest rates bend both ways. Although a federal rate cut may mean a consumer enjoys lower interest rates when borrowing, it also means the interest rates earned through savings, certificates of deposit (CDs), and other interest-bearing accounts will drop.
In many cases, this decrease in interest earnings is no reason to pull out of a savings plan entirely, because it is important to maintain an emergency fund that one can access immediately, if necessary.
But it could be a good opportunity to use any excess funds to pay off existing debts while interest rates might be lower than usual.
How Does the Federal Funds Rate Affect the Stock Market?
While the federal funds rate has no direct impact on the stock market, it can have the same kind of ripple effect that is felt in other areas of the US financial system.
Generally, lower rates make the market more attractive to investors who are looking to maximize growth. Plus, cheaper or more available money can translate to more spending and higher company earnings, which can in turn result in rising stock performance.
On the other hand, an increased rate has tended to dampen the market, since bonds can be more appealing. (An exception to this trend are stocks in the financial sector, which may have higher profits.)
What Other Factors Affect Consumer Interest Rates?
Although the Federal Reserve interest rate can impact personal finance in a variety of ways, it may take up to 12 months to feel the full effect of a change.
And it’s also only one piece of the answer to the larger question, “How are interest rates determined?”
On a consumer level, interest rates for credit cards and loans are calculated using a complex algorithm, which takes everything from personal creditworthiness to loan convertibility into consideration. Banks use benchmarks to determine an individual’s interest rate.
The federal funds rate—or federal interest rate—set by the Federal Reserve is intended to guide bank-to-bank loans, but ends up having impact across various parts of the national economy—right down to individuals’ personal finances.
For investors, the federal funds rate can be an indicator of where the market may be headed. At least, it’s a factor that investors may watch.
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