What Is the Federal Funds Rate and How Does It Affect Consumers?

One of the roles most commonly associated with the Federal Reserve is setting interest rates. But which rates does the Fed really control, and how does that affect you as a consumer?

The Federal Funds Rate

It starts with what’s known as the federal funds rate, the rate that banks charge each other for short-term loans.

The Federal Open Market Committee (FOMC) is the monetary policymaking body of the Federal Reserve. It typically meets eight times a year. During each meeting, the FOMC sets a target range for the federal funds rate. Ordinarily, the market-determined, effective federal funds rate tracks closely within the committee's target range.

How Does the Federal Funds Rate Affect Other Interest Rates?

How does the federal funds rate affect other interest rates, such as interest on savings accounts, mortgage rates or car loan rates? It’s like throwing a pebble on a pond. It creates ripple effects that diminish farther away from the center.

Short-term Interest Rates

Short-term rates are closely tied to the federal funds rate. Examples of short-term interest rates include:

• Rates on short-term Treasury bills and securities
• Private short-term money market rate

You can picture these rates as being near the center of the pebble’s ripples, says David Wheelock, St. Louis Fed senior vice president and policy advisor.

Rippling farther out from the pebble are rates more familiar to consumers in their everyday lives. These may include:

• Credit cards
• Home equity lines of credit
• Adjustable-rate mortgages
• Auto loans

The Fed Funds Rate’s Effect on the Cost of Borrowing

If the federal funds rate is rising, banks might pass on additional interest costs in the form of higher interest rates on consumer and other borrowing, but also increase the rates they pay their depositors.

When the federal funds rate is decreasing, the opposite may be true.

“If the federal funds rate is falling, then in some sense, the cost of funds for the bank is falling,” Wheelock says. “So, they’re able to pass along that to their borrowers in the form of lower interest rates on their car loans or their mortgage loans and so forth.”

Interest rates for fixed-rate 30-year mortgages are among the furthest out, as are longer-term Treasury securities and bonds. Long-term rates are less directly affected by the federal funds rate.

Monitoring Interest Rates

As the ripples spread further from the pebble, the FOMC’s job is also to make sure the waves don’t carry interest rates too far in the other direction.

For instance, raising the federal funds rate generally reflects a tightening of monetary policy. While tightening is sometimes necessary to control inflation, overdoing it could cause inflation to fall too much or slow the economy unnecessarily.

Also, Wheelock says, continued reductions to interest rates might reflect a monetary policy that’s “too loose.” In that scenario, “if you overdo it, then you’re getting too much money out in the economy and you get inflation,” Wheelock says. “And then inflation actually works in the opposite way by forcing interest rates up.”

“So, there’s a happy medium.”

This post, originally published Jan. 10, 2018, has been updated with more information.

Further Reading to Expand Your Knowledge:

• In Plain English: Making Sense of the Federal Reserve
• On the Economy: How Might Increases in the Fed Funds Rate Impact Other Interest Rates?
• On the Economy: The Fed, Interest Rates and Monetary Policy