What is the Federal Funds Rate?

The federal funds rate is the interest rate at which banks and other depository institutions led money to each other overnight to meet reserve requirements. This rate is set by the Federal Open Market Committee (FOMC) eight times a year depending on economic conditions.

Visiting the Origins

The Federal Funds Rate has a long history dating back to the creation of the Federal Reserve System in 1913. In the early years, there was no formal target for the rate. However, during the Great Depression in the 1930s, the Fed began using open market operations to stabilize the economy and prevent deflation. In 1955, the Fed introduced the Federal Funds Rate as an official policy instrument and it has been the target rate for monetary policy ever since. Over the years, the Fed has used changes in the Federal Funds Rate to influence inflation, employment, and economic growth.

The reach of the Federal Funds Rate

Changes in the Federal Funds Rate could trigger changes in practically any interest rate that an individual or institution is subject to. Think of the Federal Funds rate as the primary rate that a lender of last resort, the Federal Reserve, lends at. Any changes create a ripple effect throughout the economy, causing all borrowing rates to change in some way. Here are some examples of the types of interest rates that can be affected by changes in the Federal Funds Rate:

  1. Prime rate: The prime rate is the interest rate that banks charge their best customers. It is typically 3 percentage points above the Federal Funds Rate, so changes in the Federal Funds Rate can impact the prime rate.
  2. Treasury bill rates: Treasury bills are short-term debt securities issued by the federal government. The interest rates on these securities are closely tied to the Federal Funds Rate, so changes in the Federal Funds Rate can impact Treasury bill rates.
  3. Adjustable-rate mortgages: Adjustable-rate mortgages (ARMs) have interest rates that are tied to a benchmark rate, such as the Federal Funds Rate. When the Federal Funds Rate changes, it can cause ARMs to adjust up or down.
  4. Credit card rates: Credit card interest rates are often tied to the prime rate, so changes in the Federal Funds Rate can impact credit card rates.
  5. Car loan rates: Car loan interest rates are typically tied to the prime rate or the Treasury bill rate, so changes in the Federal Funds Rate can impact car loan rates.

Impact on the Bond Market

The Federal Funds Rate significantly impacts the bond market due to its influence on the cost of borrowing and the yield curve of corporate and government bonds. If the rate increases, the interest effect of borrowing raises and bond prices fall as yields rise. This also happens in vice versa when the rate decreases, causing bond prices to rise and yields to fall. While there is a general trend in how the Federal Funds Rate impacts borrowing, specific maturities are affected differently.

Long-term bonds, such as 10-year or 30-year Treasuries, are typically more sensitive to changes in interest rates than short-term bonds. This is because the longer the maturity of a bond, the greater the chance that inflation or other economic factors will affect the value of the bond. In addition, bonds with lower credit ratings or longer maturities are typically more sensitive to interest rate changes than bonds with higher credit ratings or shorter maturities.

The Federal Funds Rate also affects the bond market indirectly through its impact on the overall economy. When the Fed lowers the Federal Funds Rate, it can stimulate economic growth and inflation, which can be positive for the bond market. Conversely, when the Fed raises the Federal Funds Rate, it can slow economic growth and reduce inflation, which can be negative for the bond market.

As an investor in the fixed-income market, it is crucial to pay attention to the credit and time horizon risk of any bonds that you might be interested in. 

Key Takeaways

This article explored the role of the Federal Funds Rate as one of the many powers of the Federal Reserve. Beyond that, we explored how the Federal Funds Rate affects the overall interest rate environment and the bond market. Currently, the effective federal funds rate is sitting at a near 15-year high of 5.08%. Savings rates are as high as 4.5% and fixed-income securities could yield up to 6%. While Silo is a Registered Investment Advisor, this is not personal investment advice and should not be construed as so. Every individual has their own personal financial needs and should consult their investment advisor for personalized advice regarding their financial situation.