Not long ago, a close relative asked me why the Federal Reserve raises interest rates. She’s in her 70s, meaning she’s heard news about rate changes several times per year for most of her adult life and still doesn’t understand why. And she’s a smart lady. Don’t play cards with her is all I’m saying.
So you’d be forgiven if you’re not sure, either. It seems counterintuitive that the government would want to purposely make things more expensive for us. Perhaps it even seems strange to think that banks aren’t in charge of interest rates all by themselves. And if the government is that powerful, why are Apple computers still so freaking expensive? Or insulin?
And the answer to all of that is: It’s a complicated situation. Fortunately, it’s one that’s easy to understand.
What Is the Federal Funds Rate (Federal Interest Rate)?
The federal interest rate, more accurately known as the federal funds rate, is how much the government thinks banks should charge to lend money to each other. It also serves as a benchmark rate for all the loans banks give others. (That means us.)
It’s usually expressed as a range. For example, the current federal funds rate is 3.75% to 4.25%.
So let’s say Acme Bank lends you money at 5 percentage points over the rate it gets. If you take out a loan in March, when other banks charge Acme 3% interest, Acme charges you 8%. But if you wait until April, when the federal funds rate has gone up and other banks have started charging Acme 4%, you have to pay 9% interest.
But it doesn’t just affect interest rates. It influences the overall economy too. And that’s why it’s actually not all bad when they raise it. To understand how it works, it helps to understand why it exists.
Why Is There a Federal Funds Rate?
Before jumping into how the federal interest rate works, it’s helpful to know why it exists in the first place. The short answer is a wild ride that’s just as predictable as human nature.
You’ve heard of the stock market crash that preceded the Great Depression, right? In fact, you may have even been taught the crash caused the Great Depression. Well, as with many things you learned in high school — such as not putting prepositions at the end of sentences (even Merriam-Webster says you can) and that Christopher Columbus discovered America (or deserves celebration) — that’s not what it’s cracked up to be.
The stock market crash was undoubtedly bad, but it was more of a symptom of the real problem, which was greed run rampant.
And at that time, money was backed by real gold. You put your real gold in banks, who gave you paper money, which you exchanged in place of the gold. Banks then used your gold to make themselves more money. And at that time, their money-making activities were unchecked by either federal law or common decency.
And the Fed was still really new back then and didn’t have any real control over banks or foreknowledge of the impending crisis banks were helping create. So it made some mistakes. Most notably, it let the supply of money get dangerously low, meaning spotty access to it for customers, which lowered regular people’s trust in the central banking system or banks in general.
But there was also no bank insurance back then, so your money wasn’t protected, which explains the bank run to exchange paper money for real gold as people stopped trusting the value of paper money. That caused banks to crash too, often while they still owed people the gold it turns out they didn’t actually have.
The stories of the scoundrels who led us headlong into one of the biggest economic disasters the world has ever seen would make a helluva movie filled with interest and intrigue. Remember that the next time you complain about all these boring discussions of the federal funds rate. You actually want it to be that boring.
Fast-forward to the 1930s and the introduction of the Glass-Steagall Banking Act, which aimed to prevent another mass economic disaster. It created the Federal Reserve Open Committee, a group within the Federal Reserve whose job it is to set banking policies, including the federal funds rate. It also separated commercial and comparatively risky investment banking and established the Federal Deposit Insurance Corporation to insure your bank balances.
How the Federal Funds Rate Works
The Federal Reserve, or Fed, as it’s called for short, has a lot of duties. But one of its most important is to oversee all the banks that operate in the United States to ensure they’re not doing anything that could cause a problem for the rest of us — like, say, a massive recession like the Great Depression.
To that end, it requires banks to keep a certain amount of cash on hand at all times. That’s called their “reserve requirement,” and it’s a specific percentage of the money they’re holding for customers. They must deposit it into one of 12 Federal Reserve banks nationwide.
Don’t worry. That’s not necessarily the only money they have, and even if it were, the FDIC covers the rest. But because millions of dollars flow in and out of each major financial institution every day, banks can end the day with more or less money in their reserve account than they need by law.
So to ensure they’re doing what the Fed requires, banks must sometimes borrow money from one another temporarily. They charge each other interest just like any other loan, and the interest rate they use is called the federal funds rate, or federal interest rate. But they don’t get to just set that rate themselves.
The Federal Reserve Open Committee sets it. They meet several times per year and as necessary in the event of emergencies. Taking economic factors into account, they set the federal funds rate, which is actually a range rather than a single rate. Then, banks charge each other somewhere in that range to borrow money. But they also use that number to set other interest rates.
You see, lending to a fellow bank, especially when the loan is as short as overnight, is about the safest loan a bank can make. That’s why they get the lowest interest rates around.
Second to that are large corporations like Apple or Halliburton. But even they pay more to borrow money in the form of what banks call the prime rate. It’s what they charge their most creditworthy customers.
But as a consumer, you’re a lot riskier. So you pay even more than the prime rate. How much depends on your credit score and how you borrow the money.
Different types of credit come with different risk levels for lenders, and they charge more based on the level of risk. For example, people default on credit card payments far more often than car loan or mortgage payments, hence higher credit card interest rates.
So each time the Fed changes the interest rates banks charge each other, even if it’s just a little bit, it has a massive ripple effect on the rest of the economy. That’s why the committee has to take current economic conditions into account. And those affect whether they raise or lower interest rates.
How the Economy Affects Interest Rates
Interest rates are one of several ways the Federal Reserve can stimulate or restrain the economy. It’s common to wonder why anyone would want to restrain the economy — isn’t a robust economy good? And the answer to that is that yes, a robust economy is good.
But unrealistic, out-of-control growth based on empty promises and a financial outlook viewed through rose-colored glasses isn’t a robust economy. It’s the makings of the Great Depression.
Think of it like a high-speed train. If you’re on the train, so long as the suspension is stable, you can be going really fast and it may seem like everything’s fine. Great, in fact. There’s plenty of beer in the bar car, all the streaming sports and movies you could watch, and a general vibe of levity in the air. But that doesn’t mean you’re not all about to fly off the tracks, annihilating the train and all the hardworking townspeople living nearby.
And that’s where the Fed comes in. It keeps making small adjustments to keep such a disaster from happening. And sometimes, it has to make bigger adjustments. How that affects you depends on whether the rates go up or down and whether you were on the train or in town.
Why the Fed Raises Interest Rates
Higher interest rates discourage borrowing, encourage saving, and cool down the economy — bringing inflation down with them. There are several reasons the Fed would want to do that, and all have to do with slowing down that speeding train, which is populated by all the people who directly benefit from the current economic climate and those who benefit indirectly, such as business owners, investors, and their employees.
To Fight Inflation
The primary reason the Fed raises interest rates is to combat inflation.
Inflation itself is normal — good, even. It happens when there’s a mismatch in supply and demand. The Fed aims for a steady inflation rate of around 2% per year — that’s the economy having an overall 2% higher demand than supply. That makes sense when an economy is growing.
But out-of-control hyperinflation can ruin individuals’ finances, companies, and even entire countries. For example, the supply chain issues in the wake of the pandemic caused demand to outpace supply in a number of areas. The Fed and many others believed that as these “demand-pull” issues, as they’re called, corrected themselves, inflation would slow.
Apparently, they were wrong. Prices on everything from cars to groceries continued to spike, even as supply chain issues should have resolved themselves. As a result, the Fed’s previous smaller rate increases hadn’t worked, and it had to pivot sharply in November 2022 and raise interest rates by 0.75%, with more increases expected later in the year and during the next.
To Deflate Market Bubbles
When the economy overheats, bubbles form.
Consider the 2000s housing bubble. To oversimplify, low interest rates, particularly on adjustable-rate mortgages to borrowers with weak credit (those subprime loans you keep hearing about), made mortgage payments cheaper so buyers could afford to spend more on houses. That artificially inflated home prices.
When rates went up, it pushed those adjustable mortgage payments skyward. Borrowers (the people living in the town in our little train analogy) started defaulting, foreclosures started flooding the market with cheap homes, and housing prices collapsed. In other words, the bubble burst.
More government oversight of the loans during this period could have prevented such a crash. In deference to that, the 2010 Dodd-Frank Act bolstered consumer protections around loans in general but mortgages specifically and gave the Federal Reserve more power.
There’s no real consensus whether raising interest rates is the best way to fight market bubbles. But it remains an option.
To Leave Room for Growth
When things are going well, the Federal Reserve raises interest rates because they need some room to lower them when it’s time to spur economic growth. If they leave rates near zero forever, they lose one of their few real tools to boost the economy.
Why the Fed Lowers Interest Rates
Sometimes, the train’s going too slowly. That creates another kind of problem. If the train’s running late, it can’t stop to allow passengers to stretch their legs, check out the shops, and buy things they probably don’t need, anyway.
When that happens, consumer spending slows and businesses charge less. But they also produce less. That’s called deflation, and while it can be a natural result of economic growth, it can also cause problems of its own.
Before that happens, the Fed lowers interest rates to prevent the potential job loss and salary stagnation that can result.
Low interest rates encourage borrowing, making it easier for both businesses and consumers to spend money on goods and services. When consumers spend more, businesses earn more money. When businesses earn more money, they hire more workers and invest more in developing and promoting their existing employees.
How the Federal Funds Rate Affects You
The fed funds rate affects you in many ways, some more direct than others. When you hear news of the Fed lowering or lifting interest rates, you can expect several predictable impacts on your financial life.
Your Spending, Especially on Credit, Will Probably Change
The entire purpose of changing the federal funds rate is to influence consumer behavior. You’re a consumer, so that’s you.
If the Fed lowers the interest rate, you’ll probably spend more. Since credit is cheaper, you’ll start to see your credit card as a tool that makes life easier and use it more often. You may even take out loans you otherwise wouldn’t have.
Everyone’s more positive about money during these periods, so it’s possible you’ll spend more even if you don’t use credit.
But if it raises it, spending like that starts to sting. Your credit card goes from being a tool to a potential albatross as interest rates climb. So you buckle down and stop spending unless you’ve got the money in hand.
Even when you do, you might be more inclined to save it rather than spend it. Feeling more pessimistic about the economy inspires thriftiness. And it’s unlikely you’ll take out a loan unless you absolutely need to. It’s just one more monthly bill to pay.
Your Existing Credit Card or Bank Loan Interest Rates Could Change Soon
If you have fixed-rate loans, expect those to stay the same. But if you have credit cards or loans with variable interest rates, the rates you pay on those should go up or down around the same amount as the federal funds rate went up or down.
It could take a month or two, though. So if they’re going up, you may have time to look for other options. If it’s a credit card, look for a balance-transfer card with an introductory 0%-interest rate. If it’s a loan, look into refinancing.
It May Influence Your Housing Situation
If rates go down, you may decide the time is right to pounce on a mortgage at a lower rate than you could have gotten before. You may even decide to refinance your existing mortgage to get a lower interest rate or take advantage of the equity you’ve built up.
But if rates go up, that makes it more expensive to get a mortgage. That alone makes it less desirable to buy, and you wouldn’t be alone if you pressed pause on the home-buying process until rates came down. But if housing costs are steep on top of that, as has been the case a couple of times in recent memory, it can make buying even less desirable.
For example, during the pandemic, as our new normal changed how and where Americans wanted to live, housing rates climbed to peaks never before seen. Ultimately, inflation came for housing in a big, big way. Once that happens, would-be homeowners wonder if buying just means investing in what becomes a de facto money pit when housing rates inevitably fall.
If that happens, it might be wise to take the time to shore up your credit score and save for a down payment so you’ll be even better positioned to pounce when the time is right.
The Stock Market Will Move — Your Portfolio Might/Will Probably Move the Same Way
Stock benchmarks like the Dow Jones Industrial Average move if there’s even talk of the fed funds rate going up or down. And it generally moves the opposite direction.
That’s because higher interest rates increase the cost of doing business and vice versa. That can impact a company’s ability to grow, and if companies are unlikely to grow, stock prices go down.
That doesn’t mean there’s an immediate impact on businesses. But investors are human, and humans are emotional creatures. If they feel down about the market, they’re bound to make decisions that negatively affect stock performance.
If you have stocks, yours will probably go down too. But maybe not. Just because the average stock goes down doesn’t mean yours will. Remember when the Dow Jones tanked during the beginning of the pandemic? Some stocks having to do with real estate, technology, and consumer goods actually went up during that time.
The same could happen after a federal funds rate increase. Even if it doesn’t, the important thing is to hold steady unless your broker says otherwise. Success in the stock market is measured over years, not days.
The good news is that if the Fed lowers rates, stock prices tend to go up — outside the financial sector, anyway. But don’t expect to get rich off it.
Bond Rates Change
Unlike stocks, bond rates go up with interest rates. That makes new bonds with higher interest rates an easier sell.
But if the Fed lowers interest rates, older bonds may be more desirable than newer, lower-interest-rate ones, gaining new life in the secondary market. Plus, companies with the option may take advantage of lower interest rates to pay off higher-interest-rate bonds and start over with faster, shinier, newer, lower-interest-rate bonds.
That means the bonds in your investment portfolio should counteract whatever happens on the stock market — at least historically. That’s why you shouldn’t automatically panic or celebrate when interest rates change. But specifically how it affects you depends on the mix of stocks and bonds in your portfolio, both in terms of the ratio and exactly what you have of each.
Again, historically. The post-pandemic rate hikes did little to assuage worries about certain aspects of the bond market around that time. Bond rates being so high while so many companies continue to struggle financially makes investors twitchy for some reason.
That’s a very different story from the previous year, when everyone and their dog was issuing bonds, including lower-rated entities, which sold more in 2021 than ever before.
The point is that while bonds are generally one of the safer investments around, that doesn’t mean they’re without risk. The financial Boogeyman comes for every moneymaker eventually, and some aspects of the economy may defy expectations.
You Might Get a Better Savings Rate
Savings rates also go up and down with the federal funds rate. That applies to certificates of deposit, money market accounts, and traditional high-yield savings accounts.
But it could take a hot minute for them to decide exactly how much the rates should go up or down, especially at a brick-and-mortar bank, which are traditionally slower than online banks at making such changes.
And even if rates go up, don’t expect them to go up just as much as the fed funds rate. They might, but they also might not. And no matter what, you’re not going to get credit card-level interest rates on your own savings. It’s still better than getting nothing, though.
Besides, even if rates go down, there may still be the opportunity for a higher rate than you currently have as circumstances shift. So rates going down doesn’t mean you should rest easy. It might be a matter of looking at another bank.
And fortunately, when it comes to high-interest savings accounts, the advice is the same regardless of what the Fed does. Look for the highest yield you can get with the lowest fees. Bonus points if they have other features you like, such as automatic savings features.
The Federal Funds Rate & Recessions
If you were expecting this part to be in the section on how the federal funds rate affects you, you’re not alone. But you’re still wrong — not about it affecting you; about rate increases causing recessions.
Raising the federal funds rate in a vacuum is unlikely to cause a recession. In fact, it probably can’t cause one unless the Fed really goes nuts.
Recessions — of which the Great Depression is but a single, really, really awful example — aren’t usually caused by one thing unless that one thing is a cataclysmic, once-in-a-lifetime occurrence, such as a global pandemic. And even in the brief COVID recession’s case, technically, there were multiple financial causes.
But the wrong move with the federal funds rate can trigger an impending recession or fail to prevent it. It usually happens when the Fed either raises interest rates too slowly or does it too sharply or without waiting to see how things play out.
What they usually try to do when they’re fighting inflation and trying to stop a recession is opt for what they call a “soft landing.” They’re trying to slow the market without stopping the train.
But it’s also a mistake not to realize that recessions are a part of the design. It’s a feature, not a bug. Economic slowdowns are going to happen. So are much harsher economic slowdowns like recessions. The question the Fed often has to answer is less if and more how bad.
During the 1970s and early ‘80s, the country experienced something called the Great Inflation. Inflation topped out at 14%. For perspective, we’ve been sitting at roughly half that this year. Mistakes were made at the highest levels of government. It was bad, and those who remember it never want to repeat it again.
And that includes most of the people on the Federal Open Market Committee. They’d sooner cause a recession than see that level of inflation happen again.
And that’s the important thing to remember about raising and lowering the federal funds rate. Even when they make decisions you don’t like, they’re trying to avoid even more calamity. That and the fact that it could take months or even years to know whether they were right.
Boring or not, the federal funds rate directly affects your personal finances.
But remember that it’s not the only factor when it comes to what kinds of interest rates you can get when you borrow money. You can make yourself a more attractive borrower in any economy by increasing your credit score and saving more money.
And when the inevitable happens, learn to protect yourself from inflation and the effects of the interest rate increase you know is coming.