Most people know that whenever there’s an increase in the federal funds rate, aka a fed rate hike, then interest rates typically increase in the consumer financial marketplace. Higher rates make borrowing more expensive, while savings and certificate of deposit (CD) accounts may generate better returns. But where does this fed rate come from exactly?
The fed funds rate history dates back to the 1920s, and this key interest rate is a significant economic driver in the U.S. Here’s a closer look at how the fed interest rate works and why it matters.
Key Points
• The federal funds rate is a crucial economic driver, influencing borrowing costs, savings growth, and consumer prices.
• The target range for the federal funds rate is set by the Federal Open Market Committee to direct U.S. monetary policy.
• Historical rate changes have significantly impacted the U.S. economy, including during the Great Depression and Great Recession.
• Notable Fed chairs like Paul Volcker and Ben Bernanke have implemented key policies affecting the fed funds rate.
• The Fed’s approach to rate setting has evolved, emphasizing transparency and adapting to economic changes.
The Federal Funds Rate
The federal funds rate is possibly the most important interest rate in the U.S. Changes to the federal funds rate can directly impact your cost of borrowing, your savings growth, and the prices you pay for everyday goods and services. Here, details on the federal funds interest rate explained.
Definition and Purpose
In simple terms, the federal funds rate is the interest rate banks use to lend money to one another overnight. This federal funds rate, in turn, influences the rate that banks charge consumers like you to borrow money and the rates they pay on savings accounts, CDs, and interest checking accounts.
Why do banks lend to one another? To meet reserve requirements that help ensure banks have sufficient liquidity to cover transactions. Banks with excess cash in reserves will lend to banks that need short-term funds to meet their reserve requirements. So you might think of the fed funds rate as the cost of a a short-term loan between financial institutions, each of which must have a certain amount of money on reserve.
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How the Fed Uses This Rate
The target range for the federal funds rate is set by the Federal Open Market Committee (FOMC). Established through legislation passed in 1933 and 1935, the FOMC will adjust its target range for the fed funds rate depending on its stance on monetary policy.
Monetary policy refers to the actions the Fed takes to meet economic goals set by Congress, which center on maximum employment and stable prices.
Composed of the Board of Governors of the Federal Reserve System and the Reserve Bank presidents, the FOMC meets eight times per year to discuss the state of the economy, make policy decisions, and set the federal funds rate. These meetings can produce one of three outcomes impacting fed funds rate history:
• A rate hike by the Fed
• A rate cut by the Fed
• No change to the fed funds rate
The fed funds rate is a marker of the economic temperature at any given time. For instance, when inflation is rising, the Fed can institute an interest rate hike to curb spending by consumers. Theoretically, a decrease in demand should drive prices down.
If the economy is stagnating, the Fed may cut rates instead. Lower rates can spur an uptick in borrowing, helping to fuel spending and economic growth.
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Origins of the Federal Funds Rate
The FOMC is a branch of the Federal Reserve System, which is the central bank of the United States. The Federal Reserve System was officially established in 1913 when President Woodrow Wilson signed the Federal Reserve Act into law.
The Fed began using open market operations as a key tool for monetary policy in the 1920s. Open market operations is a term that refers to the purchase and sale of securities in the open market by a central bank.
Along with open market operations, the Fed relied on two other tools to implement monetary policy:
• The discount window, which allows banks to borrow money from the Federal Reserve. Loans made to banks in need are issued at the discount rate, which is typically higher than the fed funds rate.
• Purchases of bankers’ acceptances, which are money market instruments used to finance trade. In its early history, the Fed was authorized to purchase bankers’ acceptances in the open market to manage monetary policy.
Of these tools, both the discount window and bankers’ acceptances still exist, but open market operations sit at the forefront of modern monetary policy decisions.
Key Periods in Fed Funds Rate History
The fed funds rate has played an important part in the U.S. economy since its inception. Here’s a closer look at how fed funds rate history (both fed rate hikes and drops) has been impactful at different points in time.
Post-World War II Era (1950s-1960s)
These are key moments from this 1950s and 1960s:
• In 1951, the U.S. Treasury Department and Federal Reserve reached an agreement to split government debt management from monetary policy. This move was known as the Treasury-Fed Accord, and it set the stage for what would become the modern Fed.
• From 1951 to 1970, William McChesney Martin Jr. served as Fed chair. Martin believed that price stability was of utmost importance to the central bank.
• In 1957, Martin’s Fed tightened monetary policy and raised rates (which can lower demand) to curb rising inflation, leading to a recession. This was repeated in 1960, setting the stage for price stability (and the fed funds rate) to become a key marker for financial markets.
• The FOMC raised the fed funds rate in 1966 against the backdrop of a significant deficit tied to the ongoing war in Vietnam.
• In 1967, Martin attempted to negotiate a tax increase that would help ease some of the pressure on rates.
• This tax change did occur in 1968, by which time inflation was on the rise.
Martin attempted to course-correct and tighten monetary policy once again but was unsuccessful. This helped to contribute to a spike in inflation in the 1970s.
Inflation Crisis (1970s)
The 1970s experienced a period known as the Great Inflation, which technically began in the 1960s and extended into the early 1980s. Monetary policy at this time was complicated by competing goals: funding the war in Vietnam and funding a wave of new social programs introduced by the Johnson Administration.
Here are some key points to note:
• The Federal Reserve adopted “even-keel” policies during this time period, which meant it would hold interest rates steady for the period between the announcement of a Treasury issue and its sale on the open market. This strategy would eventually prove unsuccessful, however.
• The Fed, under pressure from President Nixon, expanded the money supply while lowering rates in the early part of the decade. This was presumably done because Nixon favored low unemployment even if it meant accepting rising inflation. This move backfired, however, as both inflation and unemployment continued to rise throughout the 1970s.
• By November 1979, the fed funds effective rate reached 13.18%. The effective fed funds rate is a volume-weighted median of overnight federal funds transactions. Inflation, meanwhile, topped 11%.
As you might imagine, consumers were feeling the pinch of inflation in the double digits.
Volcker Era and Inflation Control (1980s)
In 1979, Paul Volcker became the new Fed chair and swiftly announced anti-inflation measures. This is how they played out:
• Volcker’s strategy was to increase the fed funds rate and deliver a shock to the system. This move paid off as consumer demand decreased and the economy began to slow down, leading to a recession in the U.S.
• By June 1981, the effective fed funds rate had reached 19.10%; by October 1986, that number had been cut down to 5.85%. Inflation, meanwhile, hit 3.2% by 1983 proving that Volcker’s unusual measures worked.
Volcker’s term as Fed chair ended in 1987 by which time inflation was at a manageable level and unemployment had fallen below 6%. Critics of Volcker suggested that his rate hike strategy, while effective, was not the only approach he could have taken to cure the inflation problem of the early 1980s.
The Great Moderation (1990s-2007)
The Great Moderation was a period of relative economic stability that began in the early 90s and lasted up until the financial crisis of 2007-08. Inflation during this period was low, thanks to policies implemented by Volcker and his successors, Alan Greenspan and Ben Bernanke.
• During this time, the Fed took a more even approach to combating inflation that differed from its previous “go-stop”‘ policies, which often led to erratic changes in the inflation rate.
• This period also saw improved transparency and communication around how monetary policy was shaped and implemented.
However, there were bumpy times ahead.
Global Financial Crisis and Zero Lower Bound (2008-2015)
As these years unfolded, the global financial crisis saw the Fed struggling to combat the impacts of the Great Recession, which was largely sparked by a crisis in the housing market.
• Before 2007, home sales rose steadily thanks in part to the subprime mortgage market, which made mortgages more readily available to buyers.
• Mortgage loans flowed but many of these loans were predatory and in hindsight, should not have been extended to unqualified buyers.
• At the same time, the mortgage-backed securities market was booming. Mortgage-backed securities pool mortgages together into a single investment
• When homeowners (who perhaps should not have been extended mortgages in the first place, or at least not of the size they took on) began defaulting on their mortgages, a crisis emerged.
• The Fed attempted to pull the country out of the Great Recession by cutting the fed funds rate to 0%. This is what is referred to as “zero lower bound” or “zero bound,” meaning an expansionist approach in which, to stimulate the economy, short-term interest rates are dropped to zero.
• The Fed’s target funds rate remained at 0% until December 2015 when it was raised by 0.25 basis points.
The Great Recession lasted longer than any recession since World War II and saw home prices drop 30% from its high point in mid-2006 to 2009, and the S&P Index fell 57% during the period from October 2007 to March 2009.
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Normalization and COVID-19 Response (2015-Present)
The last decade or so has been marked by the following events:
• From December 2015 up until March 2020, the Fed instituted a series of rate hikes with the fed funds rate peaking at 2.25% from December 2018 through June 2019.
• The COVID-19 pandemic, however, put the Fed back on the defensive where the economy was concerned, with the fed funds rate once again going back to 0% in March 2020.
• The first post-pandemic rate adjustment was not instituted until March 2022, when the fed funds rate increased to 0.25%. This move sparked a series of rate hikes with the target fed funds rate reaching 5.25% in August 2024. (This was in part done to lower rampant inflation.)
• By September 2024, however, the Fed had cut the fed funds rate back to 4.75% as the inflation rate began to return to normal ranges.
As you can see, there has been a considerable shift in the fed funds rate in recent years.
Notable Fed Chairs and Their Rate Policies
The Fed has had 16 chairs and some have proven more memorable than others. Here are some of the key players to know in the Fed’s history.
• William McChesney Martin Jr. (1951-1970). Martin is notable for being the longest-tenured Fed chair but, perhaps more importantly, he strongly argued in favor of the Fed being able to act independently of federal pressure to shape monetary policy.
• Paul Volcker (1979-1987). Volcker is credited with bringing the runaway inflation of the early 1980s to a halt with his shock measures, which included hiking the fed funds rate.
• Alan Greenspan (1987-2006). Greenspan served as Fed chair during an extended period of economic growth when both inflation and unemployment were low.
• Ben Bernanke (2006-2014). Bernanke was responsible for steering the country through the Great Recession following the financial crisis of 2007. He was a key decision-maker behind the Fed’s choice to cut the fed funds rate to 0%.
• Janet Yellen (2014-2018). Yellen is notable for being the first woman to serve as Fed chair. During her time in the role, she continued Bernanke’s policies and implemented a gradual approach to raising rates.
The current Fed chair is Jerome Powell, who took over the role from Janet Yellen in 2018.
Impact of Historical Rate Changes
Historical fed interest rates have had some notable impacts on the economy over the decades. Here are some key events to note.
• 1920s-1930s. During this period, the Fed’s monetary policy was blamed in part for contributing to the Great Depression, which occurred following the stock market crash of 1929.
• 1950s-1960s. The Treasury-Fed Accord enabled the Fed to establish some independence from federal government pressures. Monetary policy in the 1950s and 1960s would see the fed funds rate rise and fall, which later contributed to higher inflation in the 1970s.
• 1970s. The rate hikes of the early 1970s did little to offset rising unemployment and the economic impacts of the Energy Crisis. By the late 1970s, the fed funds rates had spiked into the double-digit range, along with inflation.
• 1980s. The early 1980s saw the effective fed funds rate surpass 19% as the Fed attempted to pull the economy away from spiking inflation. The result was a deep recession which was relatively short-lived, as inflation quickly returned to normal levels.
• 1990s-early 2000s. In the 1990s and early 2000s, the fed funds rate was adjusted several times to account for economic disruptions and fluctuations. In the early 1990s, the rate was lowered to fight inflation. By the end of the decade, however, the Fed had instituted a rate hike in reaction to the bursting of the dotcom bubble, among other factors.
• Later 2000s. The housing crisis helped bring the target fed funds rate to 0%, which aided the economy as it began its recovery. Mortgage rates reached new lows during the early 2010s. Those historic lows were revisited during the COVID-19 pandemic, but mortgage rates then rose.
Currently, in late 2024, there have been two cuts to the fed funds rate this year.
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Evolution of Fed Rate Setting Practices
The way the Fed approaches monetary policy and adjustments to the fed funds rates has evolved. This evolution has been driven in part by a need to change with the times and is marked by greater transparency in how monetary policy is set.
Today, the Fed uses what’s called forward guidance to offer the public insight into what’s likely to happen with monetary policy before it actually takes place. That allows people to make financial decisions, from how they do their banking to when they buy a home, based on what they expect the outcome to be.
For example, if you know that a rate cut by the Fed is likely to be on the horizon, you might put some of your savings in a high-yield CD (certificate of deposit). That could allow you to lock in that rate before the cut is made, lowering the average savings account interest rate.
The Fed also uses quantitative easing and quantitative tightening to manage monetary policy. Quantitative easing involves buying large amounts of Treasury debt to expand the Fed’s balance sheet. Quantitative tightening allows the Fed to reduce its balance sheet by not reinvesting all of the proceeds from maturing securities.
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The Takeaway
Knowing the history of the fed funds rate can help you better understand its significance in shaping economic policy. It also enables you to plan if you know a rate cut or a rate hike might be coming soon, which can help you take the appropriate action to protect or grow your wealth.
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FAQ
What was the highest fed funds rate in history?
The highest effective fed funds rate in history occurred in June 1981, when it hit 19.10%. During the early 1980s, the Fed hiked rates to bring down rising inflation.
How often does the Fed change the rate?
The Fed meets eight times a year and it’s during these meetings that rate adjustments are discussed. There’s no specific frequency for how often the Fed changes the fed funds rate. Adjustments are made as needed to keep the country’s monetary policy on track with its dual goals of price stability and low unemployment.
How does the fed funds rate affect consumers?
The fed funds rate affects what you pay to borrow money and what you earn when you save money. Banks adjust interest rates for loans and interest-bearing deposit accounts to reflect increases or decreases in the fed funds rate.
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