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?
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) sets a target for the funds rate; ordinarily, the market-determined funds rate tracks closely the committee's target. The FOMC is the monetary policymaking body of the Federal Reserve and typically meets eight times a year.
How does the federal funds rate affect others, 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 rates are closely tied to the federal funds rate. These include:
You can picture them near the center of the pebble’s ripples, says David Wheelock, St. Louis Fed vice president and deputy director of research.
Rippling farther out from the pebble are rates more familiar to consumers in their everyday lives. These may include:
Interest rates for fixed-rate 30-year mortgages are among the furthest out, as are longer-term Treasury securities.
"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."
Meanwhile, if the federal funds rate is rising, the opposite can be true.
As the ripples spread further from the pebble, the FOMC's job is also to make sure the waves don’t carry rates too far in the other direction.
For instance, 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.”