The Federal Funds Rate: How It Affects Everything

The federal government seems to have incredible control over the financial policy in the United States, but in fact, the role of the federal government is less controlling and more of a guiding or shaping process. Some examples of this are seen in the federal funds rate and mortgage rates, both key indicators of the economy. Neither of these rates is set by the federal government.

What is the Federal Funds Rate?

The federal funds rate is the average rate that banks use to loan each other money. The loans normally occur overnight. The reason for interbank loans is because of federal regulations. One of these regulations requires that each bank keep a certain amount of cash reserves on hand. The amount is typically 10% of the demand account totals for the bank. Demand accounts are those that the owner can call at any time, such as a checking or savings account.

Each day, money flows into and out of the bank. At the end of the day some banks will have a surplus, while others will have a deficit. The banks that have a surplus of cash reserves can loan them to the backs without a reserve. The interest rate is called the federal funds rate, and is negotiated between the banks. When you hear talk about the federal funds rate, it is an average of all of these rates together, not one particular rate.

What is the Difference between the Federal Funds Rate and the Discount Rate?

Another way that a bank can replenish its cash reserves is by borrowing directly from the FDIC, this is called borrowing from the discount window, and the interest rate that is paid is called the discount rate. The discount rate is higher than the federal funds rate.

The reason that the discount rate is higher than the federal funds rate is because the federal government wants to encourage the banks to borrow from each other. Only when a bank has no better option do they borrow from the discount window. While the federal funds rate is a comparative average of all the interest rates paid overnight, the discount rate is set by the federal government.

How are Mortgage Rates Involved?

Mortgage rates have a tremendous ability to affect the economy. When mortgage interest rates are high, home sales drop and new construction grinds to a halt. The mortgage rates are set by banks, and, while loosely based in the prime rate, take into consideration other factors, such as the housing market and the credit worthiness of borrowers. Mortgage rates are set based on how secure banks feel about the economy at any given time. While much speculation occurs each time the prime rate is changed, it is important to realize that the mortgage rate does not necessarily rise and fall at the same time as the prime rate, the federal funds rate or the discount rate. However, when interest rates are low in all of these areas, they are typically low in mortgage rates as well; as they increase they subsequently increase in the housing industry as well.

Why Should the Average Citizen Care About the Federal Funds Rate?

The federal fund rate affects every part of the economy. The federal funds rate is tied to the interest rate, or the cost of borrowing money. When interest rates are low, it is less expensive to borrow money, so business expansions, home buying and other activities that involve borrowing money are more attractive. The downside of a low interest rate is that it is low across the board, if interest rates are low to borrow money, they will be low as a return in a savings account or certificate of deposit.

There is no way for the individual consumer to affect the federal funds rate, but by watching it, you can get a feel for the direction that the economy is traveling in. Banks often borrow money so that they have enough cash reserves for large projects, and an increase in overnight borrowing can point to a thriving economy. Likewise, flat levels of borrowing can mean that banks are only borrowing to replenish their demand reserves, not to fund new loans or investments.