The Federal Reserve sets the federal funds rate, which is the interest rate banks charge each other for overnight loans. This rate influences other interest rates, such as prime and mortgage rates. The Federal Reserve uses the federal funds rate to influence overall economic growth and inflation. In this blog post, we’ll discuss how the Federal Reserve’s actions can affect the economy in the short-term and long term. We’ll also look at some scenarios that could play out depending on what the Federal Reserve does with interest rates.
What is the Federal Funds Rate?
The interest rate that banks charge each other for overnight loans is called the Federal Funds Rate. The rate is set by the Federal Reserve, and it is used to influence the overall level of interest rates in the economy. It will lower the Federal Funds Rate when the Fed wants to encourage borrowing and economic activity.
This makes it cheaper for banks to borrow money, and it also drives down interest rates on loans and credit cards. As a result, consumers are more likely to borrow money and spend, which can boost economic growth. Conversely, when the Fed wants to slow down the economy, it will raise the Federal Funds Rate. This makes it more expensive for banks to borrow money, and it also increases interest rates on loans and credit cards. As a result, consumers are less likely to borrow money and spend, which can slow down economic growth.
How Fed Funds Work
The Federal Reserve formerly mandated a minimum amount of cash on hand for bank deposits each business day. This reserve demand assured that there was always enough cash on hand to begin each business day and kept them from paying out every dollar they possessed.
To lend money to other financial institutions, banks are still able to store funds in reserves, and the Federal Reserve pays interest on these funds (the IORB). If a bank is low on funds at the end of the day, it can borrow from the reserve of another institution. In this case, the FFR is useful. It’s the interest rate at which financial institutions lend to one another overnight.
The FFR is set by the banks that lend money to each other and the amount retained in reserves is the federal funds. The actual federal funds rate is calculated as the volume-weighted average of all overnight reserve transactions and is based on the interest rates set by the IORB and the ON RRP.
In February 2022, the Fed left its target FFR range unchanged at 0% to 0.25%, and in March 2022, it raised it to 0.25% to 0.50%.
As bankers will not want to pay more on a loan than they earn on their reserves and reverse repurchases, the effective FFR will remain within this range of 25 basis points. Learn more about the FFR and how it has been determined by the Federal Reserve in recent years below.
How the Fed Uses Its Rate to Control the Economy
The Fed uses its rate to control the economy by controlling the supply of money. When the economy is growing, the Fed increases the supply of money so that there is more money available to lend. This increases the money supply and makes it easier for people to borrow money, which stimulates economic growth.
However, when the economy is slowing down, the Fed decreases the money supply so that there is less money available to lend. This reduces the money supply and makes it more difficult for people to borrow money, which slows economic growth. By controlling the money supply, the Fed can influence economic growth and help to keep the economy stable.
|Fed Funds Rate from 2019 to 2022|
|Date||Targeted Fed Funds Rate|
|Jan. 30, 2019||2.25%–2.50%|
|March 20, 2019||2.25%–2.50%|
|May 1, 2019||2.25%–2.50%|
|June 19, 2019||2.25%–2.50%|
|July 31, 2019||2.00%–2.25%|
|Sept. 18, 2019||1.75%–2.00%|
|Oct. 11, 2019||1.75%–2.00%|
|Oct. 30, 2019||1.50%–1.75%|
|Dec. 11, 2019||1.50%–1.75%|
|Jan. 29, 2020||1.50%–1.75%|
|March 3, 2020||1.00%–1.25%|
|March 15, 2020||0%–0.25%|
|April 29, 2020||0%–0.25%|
|June 10, 2020||0%–0.25%|
|July 29, 2020||0%–0.25%|
|Sept. 16, 2020||0%–0.25%|
|Nov. 5, 2020||0%–0.25%|
|Dec. 16, 2020||0%–0.25%|
|Jan. 27, 2021||0%–0.25%|
|March 17, 2021||0%-0.25%|
|April 28, 2021||0%-0.25%|
|June 16, 2021||0%-0.25%|
|July 28, 2021||0%-0.25%|
|Sept. 22, 2021||0%–0.25%|
|Nov. 3, 2021||0%–0.25%|
|Dec. 15, 2021||0%–0.25%|
|Jan. 26, 2022||0%-0.25%|
|March 16, 2022||0.25%-0.50%|
|May 4, 2022||0.75%-1.00%|
|June 15, 2022||1.50%-1.75%|
|July 27, 2022||2.25%-2.5%|
How the Dollar Helps the Fed with Inflation
When the prices of goods and services go up, this is called inflation. The Federal Reserve can help control inflation by changing interest rates. When the Fed wants to slow down inflation, it will raise interest rates. This makes it more expensive for people and businesses to borrow money, which then slows down spending. Conversely, when the Fed wants to speed up inflation, it will lower interest rates. This makes borrowing money cheaper and encourages people and businesses to spend more, which then speeds up inflation. The dollar also plays a role in inflation. A strong dollar means that imported goods are cheaper, which can help to keep inflation in check. Conversely, a weak dollar can lead to higher prices for imported goods, which can cause inflation to rise. Thus, the dollar can help the Fed to control inflation by providing another tool that can be used to either speed up or slow down the rate of inflation.
The short answer is that the Federal funds rate impacts the economy in many different ways. The Fed targets a rate of 2% as a healthy base rate. That’s because when the rate is too low, inflation increases. When it is too high, it can lead to a recession. This is why the Fed meets multiple times a year and at the beginning of each meeting, they decide on a new rate. They then decide the rate they will set for the following meeting based on the previous meeting.