The impact of the federal funds rate on the economy

The federal funds rate has a rippling effect on all segments of the economy

by Kristen Stephenson

Last year, GPEC launched the Economic Monitor, a comprehensive web tool designed to provide timely, actionable insights into the state of the economy. Through an exploration of key economic indicators, the Economic Monitor offers a concise picture of health at both national and regional levels.

Each month, I’m diving into one of the indicators from the Monitor to share in greater detail what the metric measures are, why it matters to the economy and what the current numbers tell us. This month we’re going to look at the federal funds rate and how it impacts other segments of the economy.

What does the federal funds rate measure?

The federal funds rate is the interest rate in which depository institutions lend reserve balances to other depository institutions on an overnight basis. The federal funds target rate is set by the Federal Open Market Committee (FOMC), which is comprised of the Board of Governors of the Federal Reserve, the President of the New York Federal Reserve, and four other Federal Reserve bank presidents who serve on rotating one-year terms. The group convenes eight times a year to set the target rate.

The effective federal funds rate is the weighted median of interest rates across transactions guided by the target rate set by the FOMC. Generally, the target rate will be a range of 0.25% and the effective rate will fall somewhere in the middle of that range.

Why does the federal funds rate matter?

The federal funds rate has an effect that ripples through the economy. When the economy is high performing, interest rates will typically rise. If inflation increases too rapidly, the Fed will raise rates to slow the economy and lower inflation rates. The inverse is also true – if the economy is too sluggish or if inflation rates are too low, the Fed will lower rates to stimulate the economy.

Other facets of the economy are impacted as well. While mortgage rates and auto loan rates are not set by the Fed, they tend to go in the same direction as the federal funds rate – when the rate is higher, it makes doing business more expensive for lending institutions so, in turn, they raise their rates.

The stock market is very sensitive to changes in the federal funds rate. When rates are lower, stock markets spike higher since borrowing costs for public companies fall. Anticipation about what the FOMC will do regarding rates also impacts the stock market.

What do the current numbers say?

The FOMC met in late January to assess the current federal funds rate and opted to maintain the target rate at 5.25-5.5%. While the effective rate is measured daily, it has held steady at 5.33% since late July, when the Fed last raised the target rate from 5.0%-5.25% to its current rate.

The target rate was lowered to 0.0%-0.25% in the immediate aftermath of the pandemic-induced recession and was kept at that rate until March 2022, when the target was raised to 0.0%-0.5%. Following that raise, there was a consistent increase in the target rate at each FOMC meeting over the next 16 months in an effort to bring inflation under control.

The FOMC indicated that they are looking to achieve maximum employment while keeping inflation at 2% in the long run. Once they are more confident that inflation is moving towards 2% at a sustainable rate, they will likely lower the target rate. This could happen as early as later this year.

To monitor personal income in real time along with me, mapped alongside 13 other key indicators of health, visit gpec.org/monitor. We hope you find the Monitor a valuable tool in understanding the ever-changing economic landscape.

See Economic Monitor