What Is the Federal Funds Rate and What Does a Rate Hike Mean?

Changes in the fed funds rate can affect your pocketbook.

The federal funds rate is the interest rate that banks charge one another for overnight deposits. Although this might not seem very important to the average saver or borrower, the fact is that the fed funds rate affects everything from credit card rates to the amount of interest your bank will pay you on your savings. It can also influence the stock market. Here’s a look at what the fed funds rate is, the effect of fed rate hikes, and the trend of interest rates today.             

What Is the Federal Funds Rate?

The fed funds rate is set by the Federal Open Market Committee, which consists of 12 Federal Reserve officers. Technically, the rate is determined by the lending and borrowing institutions, and the average of all of these rates is the fed funds rate.

The FOMC sets a target range for this average, however, and it can influence the actual rate by transactions known as open market operations. Open market operations involve the Fed buying and selling government securities to adjust the amount of money in the banking system.

What Does a Rate Hike Mean?

The FOMC meets eight times every year to discuss interest rates and the state of the economy. The Fed raises and lowers interest rates in response to changes in the American economy. When growth slows and needs a boost, the Fed embarks on an accommodative policy, lowering rates and making money cheaper to borrow. When growth picks up, the Fed raises rates to head off inflation and an overheated economy.

Learn More: Easiest Way to Explain What an Interest Rate Is

What Are the Effects on Interest Rates?

As soon as the Fed announces a rate hike, it immediately affects other prices and rates in the American economy. Typically, banks announce similar increases in their prime rates soon after the Fed announces a rate hike.

An increase in the prime rate usually translates into higher interest rates on credit cards and mortgages. Savings rates also go higher, although they tend to increase gradually and not all at once.

Overall, when the Fed is hiking rates, you can expect to pay more for any consumer credit, from auto loans and credit cards to home mortgages and personal loans, even if those types of loans are not directly tied to the prime rate. On the plus side, interest-bearing investments, such as certificates of deposit, tend to pay more.

What Are the Stock Market Effects?

The Fed is always walking a tightrope when it comes to interest rates. A rising fed funds rate helps to keep a lid on an overheating economy and runaway inflation. But at the same time, the Fed doesn’t want to raise rates to the point where they choke off the growth in the economy. When the stock market fears that the Fed is going to raise rates too high, too fast, it can sell off, sometimes in dramatic fashion. On Feb. 8, 2018, the Dow Jones industrial average fell over 1,000 points, as market participants feared this exact scenario.

Current Federal Funds Rate

Coming out of the financial crisis of 2008, the Fed kept the fed funds rate at essentially zero until the end of December 2015. Since then, the Fed has embarked on a gradual campaign of raising rates as the economy has improved.

As of March 22, 2018, the current fed rate was 1.68 percent. The most recent fed rate increase was March 18, 2018, when the FOMC announced that the federal funds target rate was 1.5 to 1.75 percent. The “dot plot,” which indicates the Fed members’ expectations for future rate movements, suggested three rate hikes in 2018, three in 2019 and two in 2020. The fed funds rate is expected to rise to 3.4 percent by 2020.

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