Why You Should Care About the Fed Funds Rate
The federal funds rate is a big deal because it helps control how our economy works. By changing the rate, the Fed can make it easier or harder for people and businesses to borrow money, affecting how much we spend and save—understanding how the federal funds rate works can help us make smarter decisions and know what's happening in the world of finance.
In this blog, we'll explain the Fed Funds Rate in a way that's easy to understand.
Banks Borrow Money From Other Banks
Before jumping into the interworkings of the Feds and Fed Funds Rate, it is crucial to understand when/why/how banks borrow money from other banks.
All Banks, Yes Your Bank, Run Into Cash Shortages (Short Term)
When a bank has a lot of customers withdrawing money at once, or they fall short of the required amount of cash on hand, they need to borrow money. The bank will seek a loan until the cash shortage is resolved. These loans are usually paid back within 24 hours.
The Cash Shortages Usually Don't Last Longer Than 24 Hours
Even though a bank may be short on cash one day, it often receives new deposits, loan repayments, and other money inflows daily. These new funds help the bank repay the money it borrowed the previous day.
The short-term nature of these loans allows banks to manage their day-to-day cash needs while still meeting their reserve requirements and serving their customers.
How does this affect me?
Please hold tight; we will get there.
Banks Are in Business to Make Money
Banks make money when they lend other banks (and you) money. The rate they charge is, for the most part, set by the Feds (The Fed Funds Rate). If the Fed Funds Rate is around 4.5%, the banks will lend each other money at or about 4.5%. They will lend to you at something higher.
Before We Move On, Remember the Fed Funds Rate is...
...the rate a bank charges for short-term loans to another bank when facing a cash shortage. And this rate is controlled by the Fed.
The Feds Use the Fed Funds Rate to Manage Our Economy
The Fed Funds Rate is a primary tool used to combat inflation and maintain a healthy level of employment in our economy. By controlling the rate (moving it up or down) at which banks lend money to each other, they can exercise some control over our economy's current and future state.
How does that control the State of our Economy?
Imagine a bank that needs additional funds to meet its reserve requirement. The bank may borrow from another bank at the federal funds rate. The bank will likely offer consumers lower interest rates if the rate is low. Conversely, if the rate is high, the bank may be more cautious about lending, leading to higher interest rates for consumers. People tend to spend more money when rates are low and focus on saving when rates are high.
The Feds Fund Rate will make borrowing more expensive or cheaper, reducing or increasing consumer spending and slowing or speeding up economic growth. Consumers might see higher or lower interest rates on mortgages, credit cards, and other loans as the Feds Fund Rate is adjusted.
Simple Real World Example (Your Path To A Roadtrip)
Banks borrow money from other banks at or around the Fed Funds Rate. They lend you the same money but need to make a profit. They set your rate above the rate they are paying (The Fed Funds Rate). As the rate they pay goes up or down, so does yours.
- Assume the Fed Funds Rate is 4.000%
- Bank ABC lends Bank XYZ $100,000,000 @ 4.000% to resolve a cash shortage.
- Bank XYZ will offer you a loan @ 5.000% to make a profit.
- But, the economy is slow; to kickstart things, the Feds reduces the Fed Funds Rate to 3.000%
- The bank is now willing to give you a car loan at 4%. You can finally justify buying that new van. Roadtrip!
- The Feds dropped rates. You decided to buy a van. Your spending has boosted the economy.
When and How does the Fed Determine the Rate?
The Federal Open Market Committee (FOMC), meets eight times a year to discuss and assess the state of the U.S. economy. During these meetings, the FOMC evaluates various economic indicators, such as employment, inflation, and economic growth, to make data-driven decisions about the federal fund's target rate. Adjusting the target rate is one of the critical tools the FOMC uses to influence monetary policy and maintain economic stability.
The history of the Fed Funds Rate can be found here.
Taking a Closer Look
To gain a deeper understanding, explore how the Discount Rate and Discount Window work together to regulate the Fed Funds Rate. Check out this dry but informative website - The Discount Window and Discount Rate.
If you're curious about the differences between the Fed's Target and Effective rates, take a peek here - The Fed Funds Effective Rate vs. The Feds Funds Target Rate.
We are a Mortgage Bank. What About Mortgage Rates?
Yes, the Fed Funds Rate is crucial and directly correlates to our Mortgage Rates. As the Fed Funds Rate moves, so do our Mortgage Rates. However, this topic is worthy of its own blog. Stay tuned; this is coming soon.
Thanks for Checking Out This Blog. Happy Learning!