Sep 07, 2023
You are probably hearing a lot more about the Federal Reserve these days. Often called “the Fed,” the Federal Reserve System is the central bank of the United States.
Among other functions, the Fed supervises and regulates financial institutions, conducts national monetary policy, and sets the target interbank interest rate (called the “federal funds rate”).
Changes in the federal funds rate determine what banks charge to borrow money from each other, and what a bank pays to borrow from another bank can translate to what it charges a consumer to borrow from the bank. Whether you’re looking at buying a house or a car, or applying for student loans—when the Fed changes the target federal funds rate, your everyday bills and finances can be affected.
Read on to learn more about the Fed, its role in the economy, and how changes in the federal funds rate can impact the cost of living and more.
Congress passed the Federal Reserve Act to support a safer and more stable economy after several banking crises. The Federal Reserve System was formed in 1913 as an independent body to protect the nation from these recurring crises.
The Federal Reserve Act sets out three primary goals for the Federal Reserve System: maximum employment, stable prices, and moderate long-term interest rates.
The Federal Reserve System is made up of three main elements: the Board of Governors, 12 reserve banks, and the Federal Open Market Committee (FOMC), which consists of members of the Board of Governors and Reserve Bank presidents. This committee is the body that sets the target federal funds rate.
The Federal Reserve is responsible for five key functions. First, the Fed conducts national monetary policy with the goals of maximum employment and stable prices. Monetary policy refers to the tools and strategies that a nation’s central bank uses to promote economic growth and support a stable economy. The Fed sets monetary policy for the United States.
The Fed is also responsible for promoting the stability of the financial system, promoting the safety and soundness of financial institutions, promoting consumer protection and community development, and fostering safe and efficient payment and settlement systems.
The FOMC meets eight times each calendar year. During these meetings, the committee reviews economic and financial conditions. They then make monetary policy decisions, such as adjusting the target federal funds rate.
After each meeting, the FOMC releases a statement to summarize the Committee’s policy decision and the economic outlook. In addition, the Chairman of the Fed, currently Jerome Powell, gives a briefing to the press to discuss these issues and an assessment of the economy.
When the FOMC decides to change the federal funds rate, other rates may be affected—including short-term interest rates, foreign exchange rates, and long-term interest rates. Eventually, other economic indicators can be affected, too, such as the prices of consumer goods and services. Because these have an impact on company finances, employment levels may also be affected.
Inflation rates are one of the key concerns of the FOMC. High inflation rates result in higher prices for essential products and services, such as food, energy, and housing. Lowering inflation is one of the main reasons why the FOMC raises the federal funds rate.
When the news reports that the Fed has raised or lowered interest rates, they are talking about the federal funds rate. The federal funds rate is the rate at which banks in the U.S. lend to each other.
Raising and lowering the federal funds rate can maximize employment levels. It also stabilizes prices because changing the federal funds rate can lead to changes in interest rates that affect consumers.
For instance, when the Fed raises the federal funds rate, one goal is to make it more expensive to borrow money, which means people will likely decrease spending on goods and services. As a result, less money is exchanged between consumers and businesses. The economy slows down, and because there is lower consumer demand, the price of goods and services should decrease.
Over the past few years, the Fed has made multiple adjustments to the federal funds rate, which has affected the overall economy and the financial situation of consumers.
After the pandemic led to a global recession in 2020, the Fed lowered the federal funds rate to 0%.1 This boosted the economy because people could borrow more cheaply, helping them buy more expensive items, including cars and houses.
Then, these low rates, combined with government stimulus money sent to American households, increased demand dramatically. This caused a jump in consumer prices. Worried about inflation, the Fed raised the federal funds rate seven times in 2022 to slow the economy. In the same way that lowering interest rates resulted in more consumer spending, raising the interest rate reduced spending.
Since then, the Fed has continued to raise the federal funds rate. The Fed raised the rate to 5% on March 22, 2023,2 and then to 5.50% on July 26, 2023.3
The Fed’s monetary policy actions are intended to keep inflation at about 2%. At the same time, the Fed also tries to balance the economy’s health to keep employment high. But the Fed’s actions can also affect your personal finances in other ways.
When the Fed raises the target federal funds rate, it becomes more expensive for banks to borrow money. As a result, banks typically raise the interest they charge to consumers, which can lead to a decrease in consumer lending. In other words, it may be harder to get a loan or credit card. Or the interest rates on credit cards and loans might be less advantageous.
Monetary policy and interest rate fluctuations can eventually affect mortgages, car loans, lines of credit, and credit card interest rates. For example, when rates rise, payments on variable rate bills like credit cards could increase. This is one reason why consolidating higher-interest, variable rate debt with a lower-interest, fixed-rate loan can be a good idea—especially in a rising rate environment.
During periods where interest rates are higher, consumers may earn more money by placing money into savings accounts. Consumers can choose different savings account options, such as high-yield savings accounts, which can earn more interest than regular statement savings accounts.
You don’t have to track every action that the Fed takes regularly. But keeping tabs on the federal funds rate is a good idea if you are planning to make any major financial decision, such as buying a house or making home improvements.
The cost of borrowing is directly affected by the federal funds rate. That’s why it’s important to fully understand the type of loan you’re considering.
Remember, though, it’s not enough to know only about interest rates. Other factors impact what you pay to borrow money. In addition to the interest rate, some lenders may charge additional fees, such as lender fees or prepayment penalties. Lenders must tell you all the costs and fees, which factor into the annual percentage rate (APR).
To make sure you know the impact that both interest rates and APR can have on your wallet, it’s a good idea to review both when you are comparing loans.
Articles may contain information from third parties. The inclusion of such information does not imply an affiliation with the bank or bank sponsorship, endorsement, or verification regarding the third party or information.
For more detailed information, visit https://www.federalreserve.gov/monetarypolicy/fomc.htm
