When inflation is high or there’s a recession, the Federal Reserve uses monetary policy to spur or slow demand. By changing the federal funds rate, the Fed makes it cheaper or more expensive for consumers and companies to borrow money (and influencing rates on CDs and high-yield savings accounts), with the goal of maintaining a 2% inflation rate and maximizing employment.
The Fed meets eight times each year to discuss whether to keep the federal funds rate steady or adjust it. The committee increased its benchmark rate 11 times between March 2022 and July 2023 in an effort to cool inflation. Since then, it’s remained steady at a 23-year high of 5.25–5.5%.
What is the federal funds rate?
The federal funds rate is an interest rate set by the Federal Open Market Committee (FOMC). Banks charge this rate to other banks when they lend each other money, usually overnight or for a few days. Certain regulations require banks to keep a certain percentage of their customer’s money on reserve and banks will lend money back and forth to maintain the right level.
“The Federal Reserve sets a target rate for the federal funds rate, and uses its own operations to keep the rate within that range,” says Robert Goldberg, clinical associate professor of finance and economics at Adelphi University in New York.
While the federal funds rate doesn’t directly impact consumers, it does eventually trickle down to the public by influencing interest rates on consumer products like credit cards, mortgages, home equity loans, and student loans. Yields on savings products such as high-yield savings accounts and certificates of deposit (CD) are affected, too.
Though inflation has declined over the past couple of years, down to 3% from more than 9% in 2022, it still remains above the Fed’s 2% target. “The economic outlook is uncertain, and the committee is attentive to the risks to both sides of its dual mandate,” the FOMC wrote in its press release after the July 31 meeting. Yet, it “does not expect it will be appropriate to reduce the target range until it has gained greater confidence that inflation is moving sustainably toward 2%.”
Insights from Marty Green, Principal, Polunsky Beitel Green
“The Federal Reserve sounds increasingly like a broken record, although now the track may be stuck on Carly Simon’s ‘Anticipation.’ While markets continue to believe that the Fed is poised to reduce the discount rate in September, the data-dependent Fed appears to want even more data before telegraphing a definitive timing for this move. While a September cut is still very much in the cards, it doesn’t appear to be guaranteed at this point. But it sure feels like the Fed believes that the rates are getting very close to being ‘higher for long enough’ instead of ‘higher for longer.'”
Here’s a look at how rates have changed since 2022:
How is the federal funds rate determined?
The federal funds rate is determined by the FOMC, which is made up of the members of the Board of Governors; the president of the Federal Reserve Bank of New York; and 4 of the remaining 11 Reserve Bank presidents. All 12 of the Reserve Bank presidents attend FOMC meetings and participate in FOMC discussions, but only committee heads can vote on policies.
The FOMC evaluates various key economic indicators when deciding whether to raise or lower rates. Two key measures they look at are the inflation rate and unemployment rate.
When inflation is high, the Fed will increase rates to increase the cost of borrowing and cool demand in the economy. If inflation is too low, they’ll lower rates to encourage consumers to spend and stimulate demand in the economy.
The Fed is keeping the rate steady for now, in response to continued high inflation. Some were even speculating that they may hike the rate, though that doesn’t seem to be the plan for now: “The market’s positive reaction suggests traders and investors alike see the Fed easing at the September meeting because inflation continues its path lower rather than an emergency cut because the labor market is deteriorating," says Quincy Krosby, Chief Global Strategist for LPL Financial.
How does the federal funds rate directly impact consumers?
When the Fed makes changes to the federal funds rate, you’ll likely see some of the effects of this on your everyday life and finances.
1. The cost of borrowing will change. A lower federal funds rate lowers the cost of borrowing. Consumers may be more likely to borrow money for large purchases—like buying an exercise bike on a credit card or getting a loan to start a small business. Lowering the federal funds rate stimulates the economy.
But there is a downside: it can also lead to overborrowing and inflation, aka reduce your money’s purchasing power.
When rates are increased in an effort to curb inflation, the cost of borrowing becomes more expensive. This makes consumers more likely to delay major purchases to avoid paying steep interest rates and reduces the amount of money that’s circulating in the economy. This increases your money’s purchasing power.
2. Interest rates on different consumer products may fluctuate. When rates increase, banks and credit unions raise annual percentage yields (APYs) on deposit accounts.
3. You could see some stock market swings. You might also notice changes in the stock market when rates go up. When borrowing costs increase, companies face higher costs, which can potentially hurt their future growth and overall revenue.
When the market expects rate hikes, stock values tend to decline as investors anticipate lower earnings. When the Fed projects rate cuts, future projected earnings increase and stock values typically rise.
4. Higher rates may lead to a greater unemployment rate, and vice versa. Slowing down the economy by raising rates may be one way to curb inflation, but it can also impact the unemployment rate. When companies are unable to borrow money cheaply or expand, they may have larger expenses and pull back on hiring.
The takeaway
When the Fed changes interest rates, it can have a big impact on your personal finances. By staying knowledgeable about what the Fed is doing, you can make smarter money moves. For example, it could be a good time to lock in high yields by opening a CD or purchasing a Treasury. Or if you’ve been holding off on buying a home because of sky-high mortgage rates, there could be an opening in the market later this year if they do decide to make a cut. You don’t want to make decisions solely based on what you think the Fed will do but keeping afloat with the news can help guide your financial choices.
