The Fed sets a target range for the FFR. It has a lower and upper bound. Below are the target ranges announced at Federal Open Market Committee (FOMC) this year.
Rates Affected by the Fed Funds Rate
One of the most significant rates influenced by the FFR is the prime rate. That’s the prevailing interest rate that banks charge their best customers. The prime rate affects many consumer interest rates, including deposits, bank loans, credit cards, and adjustable-rate mortgages. There’s a ripple effect on the London Interbank Offered Rate (LIBOR), too. The LIBOR rate is used worldwide by banks to determine interest rates charged on adjustable-rate mortgages. Its status as the relevant price index for consumer products is due to be phased out in stages throughout 2022, with a full phaseout by June 2023. The FFR indirectly influences even longer-term interest rates. Investors want a higher rate for a longer-term Treasury note. The yields on Treasury notes indirectly drive long-term conventional mortgage interest rates.
How the Fed Uses Its Rate To Control the Economy
The FOMC uses several tools to influence interest rates and the economy. The two tools used to keep the FFR in the target rate range are:
Interest on reserve balances (IORB): The Fed pays interest on the reserves that banks keep with it.Overnight reverse repurchases (ON RRP): The Fed sells securities to banks that aren’t eligible for interest on reserve balances. It then buys them back at a higher price the next day, essentially paying the bank interest.
The committee sets a target range for the rate and then sets the IORB and ON RRP rates to manage the effective FFR. In turn, banks charge each other interest on loans that reflect these changes. These rates then dictate the rates that banks charge their customers, influencing business and consumer spending. Influencing the FFR helps the Fed manage inflation, promote maximum employment, and keep interest rates moderate. The FOMC members monitor the core inflation rate for long-term signs of inflation and adjust the rates accordingly. It can take months for a change in the rate to affect the entire economy. Planning that far ahead has led to the Fed becoming the nation’s expert in forecasting economic performance. Stock market investors should watch the monthly FOMC meetings like hawks. Analysts pay close attention to the FOMC to try and decode what the Fed will do.
How the Fed Funds Rate Maximizes Employment
It’s referred to as “expansionary monetary policy” when the Fed lowers the rate range. Banks offer lower interest rates on everything from credit card rates to student and car loans. Adjustable-rate home loans become cheaper, which improves the housing market. Homeowners feel richer and spend more. They can also take out home equity loans more easily, spending that money on home improvements and new cars. These actions stimulate the economy by increasing demand. Employers must hire more workers and increase production when demand increases. This decreases unemployment, increases consumers’ ability to spend, and feeds more demand. The Fed then sets a target range to keep a healthy level of unemployment and inflation.
How the Fed Funds Rate Manages Inflation
The opposite occurs when the Fed raises rates. This is called “contractionary monetary policy,” because it slows the economy. The cost of loans grows higher, resulting in consumers and businesses borrowing less. Adjustable-rate mortgages become more expensive. Homebuyers may only be able to afford smaller loans, which slows the housing industry. Housing prices go down, and homeowners have less equity in their homes. They may spend less, too, further slowing the economy.
How Fed Funds Work
The Federal Reserve used to require banks to keep a percentage of their deposits on hand each night. This reserve requirement prevented them from lending out every dollar they had and ensured that they had enough cash on hand to start each business day. The Fed reduced the reserve ratio to 0% as of March 2020. Banks can still hold capital in reserves for other banks to borrow from, and the Fed pays them interest on the reserves they keep (the IORB). A bank borrows from another bank’s reserve if it is short of cash at the end of the day. That’s where the FFR comes in. It’s the rate that banks charge each other for overnight loans. The balance kept in reserves are the federal funds, and the FFR is determined by the banks that lend each other money. They base their rates on the IORB and the ON RRP rates, creating the effective federal funds rate, which is the volume-weighted average of all the overnight transactions within the reserves. The Fed maintained its target FFR range at 0% to 0.25% in January 2022, then increased it to 0.25% to 0.50% in March 2022. This is a range of 25 basis points that the effective FFR will stay within because banks won’t want to pay more interest on a loan than they earn on their reserves and reverse repurchases. See more about how the Federal Reserve has set the FFR in the last few years below.
