The fed funds rate refers to the interest rate used by commercial banks to charge each other for borrowing and lending excessive Federal Reserve funds on an overnight basis. The fed funds rate is set by the Federal Open Market Committee (FOMC) 8 times a year based on the prevailing economic conditions.
Since the fed funds rate can influence short-term rates on customer loans, mortgages, credit cards, and even bring impact to stock markets, it is viewed as the most important interest rate in the world.
How does the fed funds rate control the economy?
The major function of the fed funds rate is to control inflation and keep the economy growing healthily. Members of the FOMC watch the core inflation rate and the durable goods report as economic indicators to see if there is an inflation or a recession.
Once the fed funds rate is lowered, banks are more likely to borrow funds from each other. As a result, the interest rates on credit cards will drop accordingly, thus leading consumers to make more purchases. Besides, as bank lending becomes cheaper, the business also expands.
In addition to credit card rates and bank loans, lowering the fed funds rate will cause adjustable-rate home loans to become cheaper. This means homeowners will feel richer and they would like to spend more. Lowering the fed funds rate, therefore, helps stimulate the economy.
When the fed funds rate is raised, banks will be less likely to borrow funds. Consequently, less money will be lent out from the banks, and the interest rate will become higher. This leads to more expensive loans, a reduction in business borrowing, and low housing prices. People will spend less, and the economy will slow down.