The federal funds rate, which is set by the Federal Reserve, is the target range at which banks borrow and lend money to one another overnight. But it impacts much more than just those banks.
When the Fed hikes or cuts the fed funds rate, the move impacts how much interest you pay on your mortgage, auto loan, credit card balance and more. That’s why it’s important to understand why the Fed makes adjustments to its benchmark rate and how the move affects inflation and the economy.
What is the federal funds rate?
Banks are typically required by the Fed to maintain certain amounts of cash reserves to ensure they’re stable and can make good on their loans to consumers. Sometimes, they need to borrow and lend money from other banks to meet those requirements, and that’s where the federal funds rate comes in.
This rate determines how much banks will charge each other to borrow money overnight. But there’s a trickle-down effect that hits consumers and businesses.
“It becomes an underlying instrument to set interest rate structures across the entire economy,” said Phillip Colmar, managing partner and global strategist at research firm MRB Partners.
The fed funds rate is set at a range, which is currently between 5.25% and 5.50%.
How does the federal funds rate work?
The federal funds rate determines how expensive it is to borrow money. That goes for banks borrowing from one another and for everyday consumers, since financial firms use the federal funds rate to determine interest rates on loans such as mortgages.
As the Fed lifts interest rates, the rates businesses and consumers pay on money they borrow increase as well. That means it can become more costly to have a balance on your credit card or finance a home, for example.
In turn, when the Fed cuts interest rates, it becomes less expensive to borrow money.
The federal funds rate and monetary policy
The Federal Open Market Committee (FOMC), the monetary policymaking body of the Fed, meets eight times during the year to determine its benchmark rate.The committee looks at economic indicators like inflation and employment data to determine whether the rate needs to be changed. In 2022, for example, inflation reached a four-decade high, and the FOMC hiked interest rates to try to bring down those spiraling consumer prices. The Fed also gives guidance on where it expects rates to be in the future.
How the federal funds rate impacts the economy
The federal funds rate is a tool the Fed uses to help slow down or stimulate the economy, depending on what it deems necessary in the current economic environment.
“The higher the interest rate goes, the more expensive it is to borrow to either expand as a business or to spend as a consumer,” Colmar said. “It deters you to do those activities, and it also encourages you to save more.”
When people spend more, the economy heats up, and vice versa.
To be clear, it’s not a direct influence: Consumers and businesses aren’t borrowing or lending at the fed funds rate. That activity is based on the prime rate — the base rate at which financial institutions loan money to their customers. Because the fed funds rate is a benchmark for interest rates more broadly, it also affects how much borrowers and consumers spend versus save, which impacts the economy at large.
Current federal funds rate
The current federal funds rate —a range of 5.25% to 5.50% —is a result of the Fed lifting interest rates in an effort to cool down the economy and inflation, which soared in the aftermath of the Covid-19 pandemic.
After holding rates steady towards the end of 2023, the FOMC indicated in December that three rate cuts could be coming in 2024.
“Now it’s looking to cut interest rates somewhat to bring them back down from what it perceives as restrictive levels,” Colmar said of the Fed.
The federal funds rate throughout history
Because the central bank determines the fed funds rate by looking at economic indicators, you can see how the rate has shifted depending on the current economic environment by comparing federal fund rates throughout history.
The federal funds rate hovered around record highs between 1980 and 1981 at almost 20%, while inflation was near 14.5% and unemployment was more than 7.5%. The lowest fed funds rate was a target of between 0% and 0.25%, which we saw in 2008 as a result of the housing market crash and the Great Recession. The rate stayed that low until 2015, when the Fed began to increase it again.
After a “mid-cycle adjustment” in 2019, the federal funds rate started 2020 off around 1.5% before being cut back down to 0% amid the Covid-19 pandemic. As the economy recovered, inflation soared to a 40-year high in 2022, forcing the Fed to hike rates again to where they stand now.
Inflation and the federal funds rate
The Fed typically has a target range of 2% inflation, and the federal funds rate is a tool it uses to achieve this level.
When it comes down to the basics, inflation is determined by the supply and demand for services. While the Fed’s target is inflation, it makes changes to the federal funds rate to influence the overall economy, which impacts supply and demand.
“If they need inflation to come down, then they try to weaken the economy,” Colmar said. “If inflation is too low, they try to stimulate the economy with low interest rates.”
Frequently asked questions (FAQs)
The federal funds rate is determined by the monetary policymaking body of the Federal Reserve, the FOMC, which meets eight times a year. The committee looks at indicators, such as inflation and employment data, to determine the current state of the economy and whether the rate needs to be adjusted to either help cool inflation or stimulate economic activity.
The higher the federal funds rate, the more expensive it is for banks, businesses and consumers to borrow money. This encourages them to spend less money, slowing the economy. When the rate is cut, they are more likely to spend, stimulating the economy.
The federal funds rate reached a record high in the early 1980s and record lows in 2008 and 2020. The Federal Reserve has aggressively hiked or cut rates around major economic events, such as the Great Recession and Covid-19 pandemic.
When inflation is high, the Fed typically hikes rates to make borrowing more expensive and lower demand within the economy. When inflation is low, the Fed does the opposite in hopes of increasing demand and giving the economy a boost. The goal the Fed hopes to achieve by hiking or cutting rates is to maintain an inflation rate of 2%.
