The Fed Rate, Explained

When people talk about the “Fed rate,” they are generally referring to the federal funds rate, which is the interest rate that banks charge one another for overnight borrowing.

The Federal Open Market Committee (FOMC) sets a target range for this rate as part of the Federal Reserve’s monetary policy. Although consumers and businesses don’t borrow directly at the federal funds rate, any changes in the rate can influence other interest rates throughout the economy.

And those changes can affect the availability and cost of credit, household and business spending, economic activity, employment, and inflation.

Why is the Fed Rate So Important?

Think of the federal funds rate as one link in a much larger chain.

A change in the Fed’s target rate may influence other short-term interest rates and broader financial conditions. Those conditions affect what consumers and businesses pay to borrow money, which can influence decisions ranging from buying a home to financing business expansion.

That means changes in interest rates may eventually influence:

• Mortgage and other borrowing costs
• Consumer and business spending
• Business investment
• Bond yields and prices
• Stock valuations
• Real estate activity
• The cost and availability of investment financing

These relationships aren’t necessarily immediate or predictable. The Federal Reserve notes that monetary policy’s effects on inflation and employment aren’t direct or instantaneous, and many other economic factors are at work.

What Affects the Fed Rate?

The Federal Reserve has a congressional mandate to promote maximum employment and stable prices. When determining monetary policy, Fed policymakers review a broad range of economic and financial information.

Generally, raising the target range for the federal funds rate represents a tightening of monetary policy. Higher rates may be used when inflation is elevated, or economic conditions warrant tighter financial conditions.

Lowering the target range represents an easing of monetary policy. Lower rates may be appropriate when economic activity is weak or inflation is too low.

The Fed can also leave rates unchanged while policymakers continue evaluating economic conditions.

How Often Does the Fed Meet About Interest Rates?

The FOMC holds eight regularly scheduled meetings each year, although additional meetings may be held when needed. At these meetings, policymakers review economic and financial conditions and determine the appropriate stance of monetary policy.

It’s important to know that eight scheduled meetings don’t mean eight rate changes. At any meeting, the FOMC may decide to:

• Raise rates:This tightens monetary policy and generally increases short-term interest rates and borrowing costs.
• Lower rates:This eases monetary policy and generally reduces short-term rates and borrowing costs.
• Hold rates steady:The target range stays the same while policymakers continue monitoring economic conditions.

Because each decision can affect financial conditions, and because investors may anticipate Fed decisions before they’re announced, investors may want to understand all three environments rather than focus only on whether the latest meeting resulted in a rate change.

What Happens When the Fed Pauses Interest Rates?

When people say the Fed has “paused” interest rates, they generally mean the Federal Open Market Committee (FOMC) decided to leave its target range for the federal funds rate unchanged at its latest meeting rather than raise or lower it.

A pause doesn’t necessarily signal that the Fed is finished making rate changes. Instead, the Fed may continue evaluating economic conditions before deciding whether to raise, lower, or maintain rates at future meetings.

And while the Fed rate may remain unchanged, financial conditions and market prices don’t freeze.

Investors and markets may continue responding to factors such as:

• Inflation reports
• Employment data
• Economic growth
• Treasury yields
• Consumer spending and other economic indicators
• Expectations about future Fed decisions

That last point can be particularly important. Markets often respond not only to what the Fed does today, but also to expectations about what it may do in the future. As those expectations change, Treasury yields, mortgage rates, stock and bond prices, and other market rates may move even while the federal funds rate remains unchanged.

For investors, a Fed pause is another economic development to monitor rather than an indication that investment conditions will remain unchanged.

How the Fed Rate Differs from Treasury Yields and Mortgage Rates

The federal funds rate can influence interest rates throughout the economy, but it’s not the same as the rates consumers, businesses, and investors encounter.

Here’s a quick look at the differences:

• Federal funds rate. The interest rate at which depository institutions lend balances held at the Federal Reserve to other depository institutions overnight. The Federal Reserve sets a target range for this rate as part of its monetary policy.
• Treasury yields. The return investors receive for holding U.S. Treasury securities. Treasury yields are determined in the market and can vary based on the security’s maturity as well as factors such as inflation expectations, economic conditions, and expectations for future interest rates.
• Mortgage rates. The rates lenders charge borrowers for home loans. While Fed policy can influence mortgage rates, the Fed does not directly set them. Mortgage rates are influenced by longer-term market rates, including Treasury yields, as well as conditions in the mortgage market and other factors.
• Consumer and business lending rates. Rates on products such as credit cards, auto loans, lines of credit, and business loans are set by individual lenders. They can be influenced by Fed policy and broader market rates but also depend on factors such as the type of loan, the borrower’s creditworthiness, loan terms, and lender-specific considerations.

The key distinction: The Fed directly influences a short-term benchmark rate. That influence can ripple through financial markets and borrowing costs, but Treasury yields, mortgage rates, and other lending rates do not necessarily move by the same amount—or even at the same time—as the federal funds rate.

What Should Investors Know When Fed Rates Rise, Fall, or Stay the Same?

Instead of viewing a Fed decision as a signal to buy or sell a particular investment, investors can use it as one piece of information when evaluating their overall portfolio and potential opportunities.

• If the Fed raises rates: investors may want to understand how higher borrowing costs could affect investments that depend on financing and how changing yields could affect income-producing investments.

• If the Fed lowers rates: investors may want to consider why rates are being reduced, how lower borrowing costs could affect different assets, and how changing yields may alter the relative characteristics of investments.

• If the Fed holds rates steady: investors may want to look beyond the decision itself. The Fed’s comments about inflation, employment, and economic conditions — along with expectations for future policy — can provide additional context.

In every environment, the same principle applies. Just remember that the Fed rate is one factor, not a forecast of investment performance.

Equity Trust Company is a directed custodian and does not provide tax, legal, or investment advice. Any information communicated by Equity Trust Company is for educational purposes only, and should not be construed as tax, legal or investment advice. Whenever making an investment decision, please consult with your tax attorney or financial professional.