What is the federal funds rate? How the Fed controls interest rates, explained

Without interest rates, the Federal Reserve as we know it wouldn’t exist.

The Fed uses the price of borrowing money to steer the world’s largest economy toward the committee’s two primary goals: maximum employment and stable prices. Lower rates help boost household balance sheets and incentivize spending, bolstering economic growth and hiring. Higher interest rates, however, disincentivize big-ticket purchases or investments that require financing, weighing on consumer demand or business expansions.

But each time you hear about the Fed’s interest rate decisions, it’s not as if the Fed goes to every lender or financial firm throughout the economy and dictates a specific interest rate. Instead, the Fed has control over multiple borrowing benchmarks that influence what consumers pay. One of those primary borrowing benchmarks: the federal funds rates, or fed funds rate for short.

Here’s what the fed funds rate is, how it works and how it can ultimately end up impacting your finances — whether you’re a saver or a borrower.

What is the federal funds rate?

The federal funds rate is the Fed’s main benchmark interest rate that influences how much consumers pay to borrow and how much they’re paid to save, rippling through the U.S. financial system to influence yields on certificates of deposit (CDs) and savings account, as well as rates on credit cards, auto loans or home equity lines of credit (HELOCs).

When you read headlines saying the Fed has raised, lowered or maintained interest rates, they’re referencing the Fed’s decision to adjust its key fed funds rate.

The current target range for the federal funds rate is 5.25-5.5%, the highest since 2001.

The Fed’s key interest rate has soared as high as 19-20 percent in the 1980s, when then-Fed Chair Paul Volcker was determined to defeat the worst inflation crisis in U.S. history. Meanwhile, twice throughout the Fed’s history, rates have fallen as low as a rock-bottom level of 0-0.25 percent, as central bankers first rushed to rescue the U.S. economy from the Great Recession of 2007-2009 and then the coronavirus pandemic-induced downturn that followed more than a decade later.

In a historic reversal of the low-rate era, Fed officials in March 2022 began raising interest rates by the fastest pace since the 1980s to control post-pandemic inflation. They approved 11 total rate hikes worth a whopping 5.25 percentage points. Four of those 11 rate hikes, the Fed approved a three-quarter-point increase, the largest single increases since 1994.

“It’s not that these levels are abnormally high,” McBride says, referring to the Fed’s current target range. “(A fed funds rate of) 5.5 percent is a lot closer to normal than 0 percent interest rates ever were.”

How the fed funds rate works

On its most technical basis, the fed funds rate filters out through the rest of the economy because it’s the interest rate that banks charge each other for overnight lending.

It’s not as complicated as it sounds. Just as consumers are often required to hold a certain amount of funds in their checking or savings account, the Fed throughout history has also required that banks maintain a minimum deposit balance in their own accounts at the Fed (U.S. central bankers, however, currently haven’t reinstated reserve requirements after eliminating them during the coronavirus pandemic).

Some banks have more funds than they need. Others don’t have enough to meet those nightly requirements. The banks with ample cash then lend to the banks that require the cash. Of course, since no one wants to just lend freely, it comes with an interest rate. Enter the fed funds rate. If those interest costs are rising, banks ultimately decide to pass it along to consumers in the form of higher interest rates — or higher savings yields, to woo more depositors.

Of course, banks can’t charge each other a “range.” They typically settle the interest rate at the midpoint of the Fed’s target, though it tends to fluctuate. Known as the “effective federal funds rate,” this rate is influenced by market factors of supply and demand as well as the Fed. Since the 1980s, the effective federal funds rate has averaged 4.41 percent.

The fed funds rate might not be the most important interest rate benchmark anymore

But the Fed’s monetary policy toolkit has changed almost as much as interest rates itself. The federal funds rate isn’t as effective of an interest rate benchmark as it used to be — a realization that’s likely confusing for consumers, considering that U.S. central bankers still target it.

Explaining why requires a trip back to the financial crisis of 2008. To stimulate longer-term interest rates, the Fed kickstarted a massive asset-buying program, gobbling up trillions of dollars worth of Treasurys and mortgage-backed securities. Essentially, the process expanded the money supply, with the Fed crediting banks’ accounts a value equivalent to the bond that it bought.

As a result, banks’ reserve balances rapidly expanded, and so did the Fed’s balance sheet. And even as the Fed began “normalizing” its asset holdings as the economy gradually healed from the Great Recession, there was no going back. Fed officials announced that they’d continue setting interest rates in an “ample reserves” regime, and they plunged further into that mindset more than a decade later when officials instituted even more “large-scaled asset purchases,” or LSAPs, in the aftermath of the coronavirus pandemic.

What happened when banks’ reserve balances at the Fed balloon? They have less of a reason to lend to each other overnight.

Other key interest rates that matter for the Federal Reserve

Consumers might not fixate on it as much, but Fed officials typically also adjust two other key interest rate benchmarks in tandem with fed funds rate adjustments. Sometimes, the Fed will even tweak with those individual rates when they don’t change their fed funds rate target range, in what U.S. central bankers describe as “technical” adjustments to ensure that interest rates throughout the economy match their desired target range.

• Interest on reserve balances (IORB): The IORB rate is perhaps the fed funds rate’s most important best friend. Just as consumers earn a yield for keeping cash at their bank, the Fed also pays an interest rate on banks’ reserve balances. Since it’s a risk-free rate, it acts as a floor for interest rates throughout the economy. When those rates are low, banks would prefer to lend those funds out for a greater return, increasing the availability of credit and lowering the cost of borrowing money. On the flip side, banks would prefer to keep more money at the Fed when rates are high, especially if it means they don’t have to lend to a potentially risky borrower. That increases the price of borrowing money because there’s less credit in circulation.
• Overnight reverse repurchase agreement facility (ON RRP): Not all banks earn interest on reserve balances. If they don’t have an account at the Fed, they can deposit reserves overnight in a special Fed facility, receiving a government security as collateral. The next day, the Fed buys back that security, with interest.

“It’s a different means of accomplishing the same goal,” says Eric Sims, economics professor at the University of Notre Dame. “They want to change interest rates that are relevant to you and me, but they’re doing it in a different way now.”

Because the Fed eliminated reserve requirements during the depths of the catastrophic coronavirus pandemic, officials combined the IOER and IORR into one overarching rate: the interest on reserve balances, or IORB, 2021.

How the Fed decides what to do with interest rates

If the U.S. economy were a car, the Fed would be one of its main drivers. Economic growth is the speed at which the vehicle is traveling — and interest rates are the foot pedals that give it more or less life.

It’s the driver’s job to give it enough speed to get it through the humps and hurdles, but not too much that it wrecks. Cheap borrowing costs give the U.S. economy more speed, propelling growth forward by bolstering asset prices and households’ wherewithal to spend. But more expensive rates cause firms to pull back on investing and hiring. That slows the economy down, no doubt influencing consumer spending along with it.

It’s typically easy to tell if the U.S. economy is in a downturn, mostly because unemployment tends to surge. But how does the Fed tell if the economy is running a bit too hot? By looking at inflation.

“Typically, interest rates and inflation go together,” says Gary Zimmerman, founder of MaxMyInterest.com. “In a period of high inflation, the Fed raises interest rates to slow down the economy.”

How the Fed’s key interest rates impact the economy

Yet, the sacrifice isn’t always an easy one. Interest rates are a blunt instrument, with the Fed having no way to fine-tune specific corners of the economy. Raising rates to cool inflation can mean sacrificing hiring; keeping rates too low to help more workers find work could run the economy too hot.

When the Fed pushed interest rates to their highest levels ever in the 1980s, the inflation rate plunged from a high of 14.6 percent in March 1980 to a low of 1.2 percent by December 1986. But it came with a price: Joblessness soared, rising to almost 11 percent by the end of 1982.

The trade-off between slowing the economy to defeat inflation versus letting up on the brakes to protect the job market can be especially difficult in times when inflation is still hot and unemployment starting to pick up — a stagflationary environment that consumers last endured during the 1970s and ’80s.

How the Fed’s key interest rate impacts consumers

Your wallet is also ultra-sensitive to these rate moves. If it wasn’t, the economic impact would hardly be noticeable.

Following the Fed’s benchmark, for instance, is another key borrowing rate: the prime rate, or the rate that banks charge their safest, most reliable borrowers. The prime rate tends to hold at about 3 percentage points above the fed funds rate, and it goes on to affect rates on credit cards, HELOCs, auto loans and other types of loans you can get from a bank.

The Fed doesn’t directly impact mortgages. Rather, the 10-year Treasury yield serves as the benchmark. Borrowers, however, may notice that they tend to follow a similar track.

Federal student loan interest rates, meanwhile, are left up to Congress. Lawmakers also peg those rates to the 10-year yield and set them annually.

Meanwhile, most major financial decisions all come back to the Fed — from the first-time buyers anxiously searching for an affordable home in today’s challenging low-inventory, high-rate environment to the workers wondering whether now is the time to hunt for a new position or wait it out in case of a possible recession.

Why market rates may differ from the fed funds rate

But there’s an important disclaimer: Market rates aren’t always going to hold where the fed funds rate is, even though they are influenced by them.

From a borrowing perspective, many lenders charge a margin on top of the benchmark rate. It’s mostly based on the riskiness of the borrower. Profitability can also be a factor.

“Even the federal government — which has the luxury of printing money to pay their debts — can’t borrow for free,” McBride says. “If Uncle Sam, the ultimate risk-free borrower, is paying 1.2 percent to borrow for 30 years, you can bet it will cost a few percentage points more for a consumer taking a 30-year mortgage.”

When it comes to savings, yields differ from the fed funds rate because of the way the banking system is set up, Zimmerman says. Think of it this way: When you put money in an account at a bank, you’re essentially lending the bank money. And that loan has virtually no risk, as long as you’re depositing your money in an FDIC-insured bank.

“You’re not taking on the credit risk of the bank; you’re taking on the risk of the U.S. federal government because of FDIC insurance coverage,” Zimmerman says. “Banks don’t raise their rates simply because they don’t have to. They have sufficient deposits from their customers, and those deposits are very sticky because the majority of Americans don’t pay much attention to how much they’re earning.”

Bottom line

Whether rates are high or low, it’s always going to pay to shop around. That goes for the most competitive annual percentage yield (APY) just as much as the most attractive interest rate.

As of April 30, the top-yielding online savings account was offering 5.55 percent a year in interest, up from 0.55 percent at the beginning of 2022, Bankrate data shows. Consumers should prioritize selecting an account that works for their individual needs and financial situations above yield-chasing, but parking your cash in the right place is the main way to reap the benefits of today’s high-rate environment. It can also help Americans grow their emergency fund even quicker, a pile of cash that might be crucial given the risks that the Fed may slow the economy too much.

“A lot of people are still accustomed to being a price taker rather than a price shopper,” Zimmerman says. “They have an existing bank and an existing relationship. They assume they’re powerless in this equation, but as the customer, you can shop around for the best rate. Much like you might pick the lowest interest rate for your mortgage, the best price for life insurance, you might also want to pick the best pricing and the highest rate for which bank you want to lend your money to as a depositor.”