- The federal funds rate is a target rate—a range for the interest rate the Federal Reserve would like banks to use on loans to each other.
- When the Fed raises rates, banks face higher costs and pass them onto their customers.
- The government uses federal interest rates to try to control inflation.
You may have seen the headlines: Inflation has been on the rise. And the Federal Reserve (the Fed) raised interest rates throughout 2022. Their decisions on federal interest rates impact what interest you’ll pay on personal loans, credit cards, and other financial products.
It’s worth taking the time to understand the federal interest rate, not only because it affects what you pay—or earn—in interest, but because the federal rate has a tremendous effect on the overall economy. Knowing about the Federal Reserve and federal interest rates will help you prepare for changes that might impact you financially.
What are Federal Interest Rates?
The federal interest rate is also known as the federal funds rate. It’s the rate set by the Federal Reserve Bank. “The Fed” is the nation’s central bank, which directs our monetary system and tries to stabilize the U.S. economy. The federal funds rate is a target rate—a range for the interest it would like banks to use on loans to each other. In November 2022, the target range was 3.75%-4%.
The two main jobs of the Fed are to control inflation and promote full employment. The funds rate is a key tool that the Fed uses to curb inflation, by raising the rate. It also can reduce the rate to spur economic growth.
The Fed’s policymakers constantly track inflation, unemployment rates, and many other factors. They consider both headline inflation and core inflation. Headline inflation includes all aspects of the nation’s economy. Economists like to remove highly volatile elements, like the cost of food and energy, and consider the core inflation rate. The target rate for inflation is 2%.
How do Federal Interest Rates Work?
When Fed officials raise rates, banks face higher costs. They pass those costs onto their customers. This translates into higher over-the-counter market interest for consumers. Loans become more expensive and harder to obtain, and this leads to fewer consumers and businesses borrowing. Consumers generally spend less money when the Fed rate is high, and that causes the economy to slow. Inflation is expected to drop, too.
As you might expect, when the Fed rate is low, the opposite is true. Banks offer more loans at lower rates. Then, more consumers and businesses can borrow. Usually, consumers are more comfortable spending money during these times, and the economy grows as a result. But inflation often rises, because of easier-to-obtain money and greater spending.
Sometimes, it takes months for a rate change to have an economic effect. And inflation control is a tough business. It’s difficult to forecast, and it often defies the expectations of economists.
Why does the Fed Raise and Lower Interest Rates?
The logic behind changing the federal interest rate is to help maintain a stable economy. When the economy slows, the Fed could decide to lower the target rate, making corporate and consumer borrowing easier. On the other hand, if the economy is growing too fast, the Fed may increase rates to prevent inflation. This makes the rates to borrow higher. The ongoing increases typically lead to many corporations and consumers being financially conservative during these times.
What’s the Current Federal Interest Rate?
The Federal Open Market Committee suggested a series of increases in the federal interest rate in 2022 as inflation hovered around 8%. In November, the Federal Reserve Board approved an increase of ¾ of a percentage point. That was the fourth straight increase at such a high level. The move set the federal funds range at 3.75%-4%, the highest in 14 years.
When the federal rate reaches what’s called the “terminal rate,” they don’t foresee raising it any higher. Investors try to anticipate this because of its effect on the stock and bond markets.
How the Federal Interest Rate Could Impact You as a Consumer
Changes to the federal rate impact most financial products that charge interest or return yields. But there are exceptions. Let’s look at some ways you could be impacted by changes to the federal funds rate.
- Auto loans. Changes in the Fed rate affect new fixed-rate and existing variable-rate auto loans. A change in interest rates could change your total cost for a vehicle or determine what you can afford to buy. If rates are dropping, a consumer might find it worthwhile to wait to buy. If rates are rising, it might be better to buy before rates climb even higher.
- Credit cards. Most credit cards charge a variable interest rate, but there are a few out there with fixed rates. Changes to the Fed rate will likely change the rates you pay on most credit cards. If rates rise, you may be sent a notice that your annual percentage rate (APR) is increasing. Check the notice for information about actions that you can take in response.
- Personal loans. Interest rates on current fixed-rate personal loans do not change. However, rates could change for new personal loans and existing variable-rate loans. It all depends on the direction of the Fed rate’s movement. If the rate drops, refinancing a personal loan could be beneficial.
- Mortgages. The impact here is similar to that on personal loans. But a decrease in interest rates could make it cheaper to borrow money from a home equity line of credit. You might even consider refinancing your home—if the interest rate difference is great enough to make it worthwhile.
- Private student loans. Changes to the Fed rate impact private student loans, but Congress sets the rates on federal student loans.
- Savings accounts. As the Fed rate decreases or increases, so does the annual percentage yield (APY) on savings accounts. If the Fed increases rates, you could potentially earn more money on your savings. Conversely, if the federal rate drops, other investments might become more attractive than savings accounts.
Keep an Eye on Fed Rate Changes
Keeping an eye on federal interest rate changes is a smart habit to adopt. It can be crucial to helping you prepare for changes that might impact your financial status.