On July 29, 2020, the Federal Reserve maintained its target for the federal funds rate—the benchmark for most interest rates—at a range of 0% to 0.25%. The Fed’s goal is to boost the economy, battered by the coronavirus pandemic. It first lowered the rate to almost zero on March 15, 2020.
“The ongoing public health crisis will weigh heavily on economic activity, employment, and inflation in the near term, and poses considerable risks to the economic outlook over the medium term,” the Federal Reserve’s Federal Open Market Committee said in a statement. “The Committee expects to maintain this target range until it is confident that the economy has weathered recent events and is on track to achieve its maximum employment and price stability goals.”
The fed funds rate is critically tied to the U.S. economic outlook. It directly influences prevailing interest rates such as the prime rate and affects what consumers are charged on credit cards, loans, and mortgages.
The fed funds rate is the interest rate banks charge each other to lend Federal Reserve funds overnight. Still, it’s also a tool the nation’s central bank relies on to promote economic stability, mainly by raising or lowering the cost of borrowing.
The FOMC sets the rates with the goal of helping the economy reach or maintain full employment, moderate long-term interest rates, and an inflation rate of 2%. It meets eight times a year.
Why the Fed Raises or Lowers Interest Rates
The Fed uses interest rates as a lever to grow the economy or put the brakes on it. If the economy is slowing, the Fed can lower interest rates to make it cheaper for businesses to borrow money, invest, and create jobs. Lower interest rates also tend to make consumers more eager to borrow and spend, which helps spur the economy.
On the other hand, if the economy is growing too fast and inflation is heating up, the Fed may raise interest rates to curtail spending and borrowing.
The last time the Fed cut the fed funds rate to 0.25% was in December 2008, amid the worst financial crisis since the Great Depression. The rate stayed there, at virtually zero, until 2015. Then, as the economy picked up steam, the Fed began to raise the benchmark, and it rose steadily until 2018.
In 2019, the Fed reversed course, slowly lowering rates in a sign that growth was beginning to slow. Then in 2020, the escalating outbreak of the COVID-19 coronavirus pandemic rocked not only the financial markets but the broader global economy and everyday life around the world. On March 11, 2020, the World Health Organization declared it a pandemic. By March 23, 2020, there were more than 350,000 confirmed cases and over 16,000 deaths.
How the Fed Funds Rate Works
The FOMC targets a specific level for the fed funds rate, which determines the interest rates banks charge one another for overnight loans. Banks use these loans to help them meet cash reserve requirements: Banks that are short borrow from banks that have excess.
The Fed sets a reserve requirement—a percentage of deposits a bank must keep on hand. Along with cutting its benchmark rate, the Fed lowered this requirement to zero (from as high as 10%) to encourage lending to households and businesses in need. The new requirement took effect on March 26, 2020.
Before the financial crisis, the Fed controlled the fed funds rate by buying and selling U.S. government securities on the open market. When the Fed buys securities, that purchase increases the reserves of the bank associated with the sale, which makes the bank more likely to lend. To attract borrowers, the bank lowers interest rates, including the rate it charges other banks.
When the Fed sells a security, the opposite happens. Bank reserves fall, making the bank more likely to borrow and causing the fed funds rate to rise. These shifts in the fed fund rate ripple through the rest of the credit markets, influencing other short-term interest rates such as savings, bank loans, credit card interest rates, and adjustable-rate mortgages.
The Fed’s actions during the financial crisis and ensuing recession had the effect of ballooning banks’ reserve balances. As a result, banks didn’t need to borrow from one another to meet reserve requirements. The Federal Reserve could no longer rely on reserve balance manipulation to control interest rates. Because of that, the Fed has developed other tools to affect the rate.
Changes in How the Fed Sets the Rate
The Fed sets a target range for the fed funds rate. It started back in October 2008, when the Fed began paying interest on reserves (IOR), but to a limited number of institutions. This action was intended as the floor on the fed funds rate. After all, banks won’t lend to each other at a lower rate than what they’re getting from the Fed.
Eventually, the Fed realized the IOR wasn’t sufficient. It needed a sub-floor, so in 2013 it added another tool to help it control the target rate: the overnight reverse repurchase agreement facility (ON RRP, or “reverse repo”). This program is available to a broader range of financial institutions than IOR.
With the ON RPP, the Fed agrees to sell a security and buy it back at a higher price, which is effectively the interest rate. This rate is set high enough to attract buyers, but below IOR. When banks need to borrow from one another, they do so within the range bounded by IOR and ON RPP. And when the Fed acts to raise or lower interest rates, it adjusts both IOR and ON RPP.
How Other Interest Rates Are Determined
The fed funds rate is one of the most significant leading economic indicators in the world. Its importance is psychological as well as financial, as many of the interest rates businesses and consumers pay are influenced by it, either directly and indirectly. For example, banks often choose to set their prime rate, which serves as the baseline for many loans and credit cards, using the fed funds rate as a guide.
Variable interest rates for credit cards and other consumer loans rely on the prime rate, which in turn is influenced by the fed funds rate.
Not all loans rely on the prime lending rate. In fact, the interest rates for 30-year mortgages correlate with the yield on the 10-year Treasury note. That’s because investors who are interested in safe long-term returns on their investments see lots in common between the two—but not because one rate is determined by the other. Ultimately, supply and demand determine the rates for both.
Another important benchmark interest rate that is not set by the Fed is the London Interbank Offered Rate (LIBOR). It is the average interest rate major global banks charge each other to borrow. LIBOR is calculated daily and is the basis for a host of commercial and consumer interest rates, from corporate bonds to adjustable-rate mortgages.