Federal Reserve Interest Rates, Explained
If you pay attention to the news, you have probably noticed that the Federal Reserve (or Fed, for short) makes headlines every so often. The Fed has recently been in the spotlight because it has been making policy moves to combat rising prices. In the face of the highest inflation rate in 40 years, the Fed has raised interest rates – otherwise known as the federal funds rate — to between 5.00% and 5.25% as of early July 2023.
There’s a connection between the Fed’s interest rate decisions, the national economy, and your personal finances. The Fed works to help balance the economy over time—and its actions and influence on monetary policy can affect household finances. Here’s what consumers should know about the Federal Reserve interest rate and how it trickles down to the level of individual wallets.
What Is the Federal Funds Rate?
The federal funds rate, or federal interest rate, is a target interest rate assessed on the bank-to-bank level. It’s the rate at which banks charge each other for loans borrowed or lent overnight.
The federal funds rate is not directly connected to consumer interest rates, like those that might be paid on a personal loan or mortgage. But it can significantly influence those interest rates and, over time, can impact how businesses and individuals access lines of credit.
How Is the Federal Funds Rate Set?
The Federal Open Market Committee (FOMC) sets the federal funds rate. The FOMC is a 12-member group made up of seven members of the Board of Governors of the Federal Reserve System; the president of the Federal Reserve Bank of New York; and four of the remaining eleven Reserve Bank presidents, who serve one-year terms on a rotating basis.
The FOMC meets a minimum of eight times per year—though the committee will meet more often than that if deemed necessary. The group decides the Fed’s interest rate policy based on key economic indicators that may show signs of inflation, rising unemployment, recession, or other issues that may impact economic growth.
The FOMC often slashes rates in response to market turmoil as an attempt to boost the economy. Lower rates may make it easier for businesses and individuals to take out loans, thus stimulating the economy through more spending. The Federal Reserve enacted a zero-interest rate policy in 2008 and maintained it for seven years to boost the economy following the Great Recession.
On the other hand, the FOMC may raise interest rates when the economy is strong to prevent an overheated economy and keep inflation in check. Higher interest rates make borrowing more expensive, disincentivizing businesses and households from taking out loans for consumption and investment. Because of this, higher interest rates theoretically will cool the economy.
Current Federal Funds Rate
As noted above, the current federal funds rate is between 5.00% and 5.25% as of early July 2023. The FOMC raised interest rates rapidly throughout 2022 in an effort to bring down inflation, which was at the country’s highest levels since the 1980s.
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, federal fund targets have varied widely depending on the economic outlook. The federal funds rate was as high as 20% in the early 1980s due to inflation and as low as 0.0% to 0.25% in the post-Covid-19 environment when the Fed used its monetary policy to stimulate the economy.
How Does the Fed Influence the Economy?
The Federal Reserve System is the U.S. central bank. The Fed is the primary regulator of the U.S. financial system and is made up of a dozen regional banks, each of which is localized to a specific geographical region in the country.
The Fed has a wide range of financial duties and powers to take measures to ensure systemic financial and economic stability. These duties include:
• Maintaining widespread financial stability, in part by setting interest rates
• Supervising and regulating smaller banks
• Conducting and implementing national monetary policy
• Providing financial services like operating the national payments system
The Fed has authority over other U.S. 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.
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How Does the Federal Funds Rate Affect Interest Rates?
Although the federal funds rate doesn’t directly influence 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’s rate changes impact 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 various 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 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 mainly based 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 5.00%, a bank’s prime interest rate might be 8.00%.
Even for consumers who don’t have excellent credit, the prime interest rate is important; 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 affect existing lines of credit that have variable interest rates.
Savings Accounts and Certificates of Deposit
Interest rates bend both ways. Although a federal rate hike may mean a consumer sees higher interest rates when borrowing, it also means the interest rates earned through savings, certificates of deposit (CDs), and other interest-bearing accounts will increase.
In many cases, this increase in interest earnings influences consumers to save more, which can help as an incentive to build and maintain an emergency fund that one can access immediately, if necessary.
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 indirect, ripple effect that is felt in other areas of the U.S. financial system.
Generally, lower rates make the market more attractive to investors looking to maximize growth. Because investors cannot get an attractive rate in a savings account or with lower-risk bonds, they will put money into higher-risk assets like growth stocks to get an ideal return. Plus, cheaper or more available money can translate to more spending and higher company earnings, resulting in rising stock performance.
On the other hand, higher interest rates tend to dampen the stock market since investors usually prefer to invest in lower-risk assets like bonds that may offer an attractive yield in a high-interest rate environment.
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What Other Factors Affect Consumer Interest Rates?
Although the Federal Reserve interest rate can impact personal finance basics in various ways, it may take up to 12 months to feel the full effect of a change.
On a consumer level, financial institutions use complex algorithms to calculate interest rates for credit cards and other loans. These algorithms consider everything from personal creditworthiness to loan convertibility to the prime interest rate to determine an individual’s interest rate.
The Takeaway
The federal funds rate — or federal interest rate — set by the Federal Reserve is intended to guide bank-to-bank loans but ends up impacting various parts of the national economy—down to individuals’ personal finances. For investors, changes in the federal funds rate can indicate where the stock market may be headed. At least, it’s a factor that investors may watch.
If you’re paying attention to the Federal Reserve interest rate policy changes and want to make investing decisions based on those moves, SoFi can help. With a SoFi Invest® online brokerage account, you can trade stocks and exchange-traded funds (ETFs) for as little as $5.
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