Investing Basics: How Does the Fed Funds Rate Impact Interest Rates

December 21, 2015

On Wednesday, December 16, the Federal Reserve announced the long awaited rise in the Fed’s official borrowing rate.  But what does it mean when you hear in the news that the Fed has raised rates?  There is a broad perception 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 shifted is what is known as 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 control the interest rate banks charge each other to borrow from each other.

 

It can take months, an estimated 12-18 months for a change in the Fed Funds rate to find its way all the way through the economy.  Essentially what the Fed is doing is increasing 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 their ‘cost’ of money is going up, banks are compelled to increase the rate of interest that they charge on new loans.

Note, however, that there are many other factors that determine overall interest rates, especially for long-term loans like mortgages.  Remember that the Federal Funds Rate is an overnight rate, and is very different from a 30-year mortgage.  Therefore, the change the Fed is making is likely to impact short-term loans more directly.  In the long run, 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 rising 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.

 

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