Interest Rates: How the Fed Funds rate affects the average American
The role of the Federal Reserve (the "Fed") is to regulate and supply money to private banks. When banks borrow directly from the Fed they pay an interest rate known as the Discount rate. When banks lend to one another, they pay a rate referred to as the Fed Funds rate.
Banks are required to keep a certain amount of cash on hand in order to cover any obligations they may have. When a bank has extra cash it may lend to another bank that needs to shore up its own reserves. The rate charged for these short-term overnight loans (the Fed Funds rate) is set each month by a panel of 12 experts – including Federal Reserve Chairman Bernanke – who serve on the Federal Reserve Open Market Committee. The committee can leave the Fed Funds the same, raise it, or lower it, depending upon its view of what is best for the economy.
Banks try to make a profit by lending their money to their customers in return for charging interest on those loans. The difference between what a bank pays (the Fed Funds rate) and what it charges customers for consumer loans determines the bank’s profit margin. Once the Fed Funds rate is set, banks know how much they have to pay for their own money, so they use it as a benchmark to decide what rates to charge customers for such things as mortgage loans and credit cards.
Lowering interest rates stimulates economic activity because it makes it less expensive to borrow money. Individuals and business borrow and buy more products and services, which helps employ more people - who can then earn more and spend it to continue a cycle that keeps boosting the economy.
But if money is too easy to get, people tend to pay too much for the things they buy - without regard to their actual value. This leads to price inflation, which makes products and services so expensive that people eventually stop buying and the economy slows.
Raising interest rates also puts the brakes on the economy because households and businesses cannot afford to borrow money. So for American households the most important rate to watch is the Fed Funds rate, because it usually has the most direct influence over the consumer economy and how much average borrowers pay for their various kinds of loans.
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Banks are required to keep a certain amount of cash on hand in order to cover any obligations they may have. When a bank has extra cash it may lend to another bank that needs to shore up its own reserves. The rate charged for these short-term overnight loans (the Fed Funds rate) is set each month by a panel of 12 experts – including Federal Reserve Chairman Bernanke – who serve on the Federal Reserve Open Market Committee. The committee can leave the Fed Funds the same, raise it, or lower it, depending upon its view of what is best for the economy.
Banks try to make a profit by lending their money to their customers in return for charging interest on those loans. The difference between what a bank pays (the Fed Funds rate) and what it charges customers for consumer loans determines the bank’s profit margin. Once the Fed Funds rate is set, banks know how much they have to pay for their own money, so they use it as a benchmark to decide what rates to charge customers for such things as mortgage loans and credit cards.
Lowering interest rates stimulates economic activity because it makes it less expensive to borrow money. Individuals and business borrow and buy more products and services, which helps employ more people - who can then earn more and spend it to continue a cycle that keeps boosting the economy.
But if money is too easy to get, people tend to pay too much for the things they buy - without regard to their actual value. This leads to price inflation, which makes products and services so expensive that people eventually stop buying and the economy slows.
Raising interest rates also puts the brakes on the economy because households and businesses cannot afford to borrow money. So for American households the most important rate to watch is the Fed Funds rate, because it usually has the most direct influence over the consumer economy and how much average borrowers pay for their various kinds of loans.
Read more: