The Fed Funds Rate
On Tuesday, August 7th, The Federal Open Market Committee again decided to leave the Fed Funds Rate unchanged at 5.25%. Many readers may be left wondering how such decisions affect them.
The Federal Open Market Committee (FOMC) is a section of The Federal Reserve that is tasked with setting US monetary policy. One of its main tools to accomplish this task is the setting of the nominal value of the Fed Funds Rate. The Committee meets about every 6 weeks to discuss the rate and issue a statement announcing the decisions from the meeting.
The Fed Funds Rate is the interest rate that financial institutions charge one another for overnight loans. Overnight loans are necessary because each bank is required by law to have 10% of its transaction deposits held in vault cash or in its accounts with the Federal Reserve Bank at the close of business each day.
When you deposit your money in a bank, the money doesn’t just go into the vault and wait until you need it. The bank may loan your money out to other customers, or invest it in some other way. To satisfy the 10% requirement, banks with more money than required at the end of the day will loan it out to banks that are short. The interest rate will be decided on between the two banks. The following day, the short bank repays the loan. The weighted average of all of the overnight loans is the effective Fed Funds Rate. The FOMC is able to influence the effective rate towards the nominal rate that they decide on through the buying and selling of bonds.
If you’ve been waiting for the personal relevance of this topic, here it is: Financial institutions tend to set their internal Prime Rate based on the Fed Funds Rate. The Prime Rate tends to run about 3% higher than the Fed Funds Rate, which means it’s currently at 8.25%. The Prime Rate tends to directly affect you for the following reason: Unlike P2P loans from Lending Club, which have a fixed interest rate, the interest rate that you pay on your Home Equity Line of Credit, Adjustable Rate Mortgage, and Credit Cards are often tied to the issuing bank’s prime rate.
If the Federal Reserve is concerned that the economy is expanding too rapidly, which may lead to inflation, it can raise the Fed Funds Rate. This will result in the prime rate rising, which will then make credit more expensive. More expensive credit may cause businesses to raise prices and you to spend less due to those higher prices and the fact that your credit is also more expensive. In this way, an increase of the Fed Funds Rate can effectively slow down the entire economy. Similarly, a reduction in the rate could speed up an economy if the FOMC was concerned that it was running too slowly or headed for a recession.
Wednesday, August 15th, 2007 at 7:38 am