Investing Basics: What does it mean when the Federal Reserve Lowers Interest Rates

On September 17^th, 2025, the Federal Reserve announced the highly anticipated 0.25% drop in the Fed Funds rate.  But what does it mean when you hear in the news that the Fed has lowered rates? Do mortgage rates or car loans automatically fall by 0.25%? The quick answer is no.  There is a broad misperception that the Federal Reserve sets interest rates for things like company loans, mortgages, car loans and even credit cards, but the Feds impact on interest rates in the broader economy is indirect.  In fact, even though the Fed has an enormous effect on rates, the market ultimately is the guide to what companies and individuals are charged for loans.

The interest rate that the Federal Reserve changed is the ‘federal funds rate” which is the rate that banks charge each other for overnight loans.  These loans are made because the Fed requires banks to hold a certain amount of money in their accounts at the Fed each night.  Banks with excess reserves are able to lend to banks that need reserves.  The Fed doesn’t even ‘set’ this rate but targets a rate and because the Fed controls the supply of these reserves, it can also strongly influence the interest rate banks charge each other to borrow from each other.

Longer term interest rates, for things like home mortgages and cars, are influenced by many factors, not just the Fed Funds rate. For example, many argue that long-term inflation expectations and long-term economic growth forecasts are more important influences on long-term interest rates than the Fed Funds rate. This week provides a good example.  In the week after the Federal Reserve’s decision to lower the Fed Funds rate by 0.25%, the average mortgage rate increased by 0.4% according to Freddie Mac.

So, what impact does the Fed Funds rate have? When the Federal Reserve lowers the Fed Funds rate it is lowering the ‘cost’ of money to the banks.  Banks make money on the difference between the interest rates that they pay (to the fed, other banks, bond markets, and depositors) and the interest rates that they charge (to households and companies).  Since the bank’s ‘cost’ of money is going down as the Fed Funds rate goes down, they have more room to lower the interest rates that they charge. But the Federal Funds Rate is an overnight rate and is very different from a 30-year mortgage.  If the bank believes that inflation will remain high, they will still want to charge more for a 30-year mortgage, despite the lower Fed Funds interest rate.

Therefore, the change the Fed is making is likely to impact short term loans more directly.  In the long-term things like inflation expectations, economic growth, and demand for borrowing can be more important than the Federal Funds Rate.  Be wary of people that forecast lower interest rates as a given.  It is likely, but hardly mechanical.

If you are interested in learning more about the Fed’s recent actions and what it might mean for the overall economy and your portfolio, please feel free to give us a call.