The Federal Reserve is hiking the federal funds rate multiple times in 2022 in an attempt to depress 40-year-high inflation. The move is meant to reverse easy monetary policies put in place at the start of the pandemic.
From March 15, 2020, to March 16, 2022, the Fed’s target interest rate was set to “near zero,” a range of 0-0.25%. While much has been made of the impending increases expected throughout 2022, if you’re still a little confused about who pays the federal funds rate and how it impacts other interest rates across the board, you’re not alone.
Definition
The federal funds rate is the target overnight interest rate banks charge each other to borrow money.
How it works
The Federal Reserve typically requires banks to have a certain amount of cash on hand every night. The reserve requirement is a percentage of the bank’s total deposits and it is often held in an account at the Federal Reserve.
A lot of times, lending institutions try to stay as close to the minimum reserve requirement as possible, but sometimes they dip under. To meet the reserve requirement that night, a bank will borrow money from another bank that has excess reserves. That’s when the receiving bank is charged the effective federal funds rate on the loan.
Why it matters
The goal of the Fed is to promote a healthy economy. The federal funds rate is one of its tools, along with open market operations (maybe we’ll get into this one in a future Word on the Street).
When the Federal Reserve wants to stimulate the economy, it lowers the short-term borrowing rate for banks, which typically prompts banks to also lower rates they charge on loans to customers.
When the COVID-19 pandemic hit in 2020, the Fed moved the target interest rate to near-zero and borrowing rates fell across the board, from the prime rate (generally 3% higher than the top end of the federal funds rate) to credit cards to auto loans and even 30-year mortgages. Though indirectly linked, 30-year fixed mortgage rates dropped to the lowest levels in history nine months later.
On the flip side, when the economy is too stimulated, the Fed will raise the benchmark rate to try to tamp down inflation.
“I think there’s quite a bit of room to raise interest rates,” Federal Reserve Chair Jerome Powell said in January.
Because lending between banks becomes more expensive as the target rate rises, customer business with banks gets pricier too. The silver lining in increasing interest rates translates to savings accounts as well, so banks will pay you more for your reserves.
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