The Federal Reserve System, commonly called the Fed, is the central banking system of the United States. It was established in 1913 with the passes of the Federal Reserve Act and ever since, it has been a mainstay of the American monetary system. The Fed influences the money supply, interest rates, and other aspects of the economy. One of the most important tools of the Fed is controlling the federal funds rate, or FFR. This rate is the interest rate at which banks lend to each other overnight. Since the FFR is a primary measure of borrowing costs, it has a powerful influence on the overall financial system and the economy as a whole.
The FFR is determined by the Federal Open Market Committee (FOMC), more commonly called the Fed board. The FOMC meets about eight times a year to discuss monetary policy and other economic matters. At each meeting, the committee votes on whether to increase, decrease, or keep the federal funds rate the same. Their decision is based on numerous factors such as inflation, GDP growth, and employment.
The federal funds rate and other short-term rates are closely linked. When the Fed raises the FFR, other interest rates quickly follow suit, such as mortgage rates and car loan rates. This means that people and businesses must pay more for loans and credit cards. Similarly, when the Fed lowers the FFR, other interest rates also fall, making it easier to obtain loans and credit.
The FFR is one tool the Fed uses to stimulate the economy. When the economy is slowing down, the Fed will lower the FFR to encourage borrowing and spending, a policy known as easing. Conversely, when the economy is expanding too quickly or inflation is high, the Fed will increase the FFR as a way of cooling off the economy, a policy known as tightening.
The federal funds rate has a major impact on the stock market and overall economy. When the FFR is low, it often leads to an influx of investment, causing stocks to rise and the economy to grow. However, when the FFR is raised, the opposite occurs. Investment is discouraged and stocks tend to fall.
The current FFR is 2.20%-2.25%, which is historically quite low. In December 2015, it was set at 0.50%-0.75%, and during the Great Recession of 2008-09, it dropped to 0-0.25%. In response to the Covid-19 pandemic, the Fed drastically reduced the rate to an all-time low of 0-0.25%, where it has remained since March 2020.
The federal funds rate is a critical component of the overall American financial system. It influences borrowing costs and helps the Fed regulate inflation, employment, and economic growth. By precisely controlling the FFR, the Fed can adjust the money supply and manage the overall health of the economy.
