The Most Powerful Interest Rate in the World

The Most Powerful Interest Rate in the World

Fed Funds Rate, It’s Impact, and How It Works

By Kimberly Amadeo   Updated October 30, 2019

The fed funds rate is the interest rate banks charge each other to lend Federal Reserve funds overnight, but it's also a tool the nation's central bank uses to control U.S. economic growth and a benchmark for interest rates on credit cards, mortgages, bank loans, and more.

Arguably, that makes it the most important interest rate in the world.

As of Oct. 30, 2019, the fed funds rate stood at 1.5%–1.75%. Banks use it as a base for all other short-term interest rates.

One of the most significant rates influenced by the fed funds rate is the prime rate, the prevailing rate banks charge their best customers. The prime rate affects many consumer interest rates, including rates on deposits, bank loans, credit cards, and adjustable-rate mortgages.1

There's a ripple effect on the London Interbank Offered Rate too. Libor, as it's commonly called, is the rate banks charge each other for one-month, three-month, six-month, and one-year loans.

Longer-term interest rates are indirectly influenced. Investors want a higher rate for a longer-term Treasury note. The yields on Treasury notes drive long-term conventional mortgage interest rates.

Recent Change in Direction

On Oct. 30, 2019, the Federal Reserve's Federal Open Market Committee lowered the fed funds rate to 1.5%-1.75%. This was the FOMC's third cut in 2019, following nine hikes since December 2015. Prior to that, the rate had been 0% since December 2008. To combat the financial crisis, the FOMC had aggressively lowered it 10 times in the prior 14 months.2

How the Fed Uses Its Rate to Control the Economy

The FOMC changes the fed funds rate to control inflation and maintain healthy economic growth. The FOMC members watch economic indicators for signs of inflation or recession. The key indicator of inflation is the core inflation rate. The critical indicator for a recession is the durable goods report.

It can take 12 to 18 months for a change in the rate to affect the entire economy. To plan that far ahead, the Fed has become the nation’s expert in forecasting the economy. The Federal Reserve employs 450 staff, about half of whom are Ph.D. economists.

When the Fed raises rates, it's called contractionary monetary policy. A higher fed funds rate means banks are less able to borrow money to keep their reserves at the mandated level. (More on this below.)

As a result, they lend less money out. The money they do lend will be at a higher rate because they are borrowing money at a higher fed funds rate. Because loans are harder to get and more expensive, businesses will be less likely to borrow. This will slow down the economy.

When this happens, adjustable-rate mortgages become more expensive. Homebuyers can only afford smaller loans, which slows the housing industry. Housing prices go down. Homeowners have less equity in their homes and feel poorer. They spend less, thereby further slowing the economy.

The fed funds rate has been as high as 20%, back in 1979. Fed Chair Paul Volcker used it to combat double-digit inflation.

To continue reading, please go to the original article here:

https://www.thebalance.com/current-federal-reserve-interest-rates-4770718