The Federal Funds Rate

With the second FOMC meeting of 2022 in the books. Now is a good time to take a deeper look at what the Federal funds rate is and how it correlates to everyday life. As of March 16th, 2022 the Federal Reserve raised interest rates for the first time since 2018. This move was to work towards tackling inflation, you can read our recap of the meeting here

The Federal Funds Rate

The Federal Funds rate refers to the percentage rate that the FOMC decides commercial banks should charge to lend each other monetary reserves. Now, although the FOMC sets the target rate, the banks may influence the going market rate depending on the supply and demand for lending excess reserves at the time. This is important because by federal law, commercial banks must keep a percentage of their total deposits in a non-interest bearing federal reserve bank account each night. This is the reserve requirement which is kept to allow banks to cover client withdrawals and other institutional obligations.

If banks have a shortfall of funds needed to meet the reserve requirement, they may borrow an excess amount from another bank to meet this requirement.  The federal funds rate is the “target” interest rate for the loan between the banks.  A bank’s end-of-the-day balance in the federal reserve accounts averaged over the two-week reserve maintenance periods are used to determine if the bank has met their requirement. 

How does the federal funds rate impact daily life?

The interest rate determined by the FOMC has far reaching implications depending if they are increased or decreased following following a Federal Reserve meeting. When the Federal reserve employs policies of quantitative  easing, it is “cheaper” to borrow money as interest rates are low. This helps increase spending in the economy and often the stock market will reflect it with an increase in share prices.

Although it is not only corporations that find it appealing to borrow when interest rates are kept low, the federal funds rate impacts mortgage, auto, and credit card interest rates as well. With the increase in the federal rate, mortgage rates have risen over 4% for the first time since 2019.  This adds another layer of complexity to an already complicated housing market. While higher interest rates on mortgages may slow down the red-hot housing market, it will make purchasing a home more difficult for buyers who are already struggling to keep up with record property values in some areas of the US. 

The interest rates consumers looking to finance big purchases may not skyrocket, but as the FOMC continues to increase their target rate. Rises of 1-2% may be seen towards the end of 2022, which often affects the requirements lenders require from clients to qualify for a prime lending rate. For consumers, this may look like, lenders requiring higher credit scores, and down payment requirements prior to receiving a new loan. For short term loans such as auto loans, the increased percentage may only add a few hundred dollars over the life of the loan. While the long term financing seen with mortgages, 1-2% can add up over the 30 year average loan span. 

With the FOMC still scheduled to meet 7 more times in 2022, it will be important to understand what their actions and policies imply for the market as a whole. The monetary policy set by them does not occur in a bubble and it is intended to garner certain reactions from the market that they decided the economy needs. In our case, we are seeing them try to slow down inflation, so the pumping of money into the economy will be slowed down.

 

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