The federal funds rate is defined as the suggested interest at which banks can lend money to each other. The federal funds rate is considered a targeted interest rate because it’s set by the Federal Open Market Committee (FOMC). The Federal Open Market Committee is the chief decision-making board within the Federal Reserve. It sets monetary policy aimed at reaching the Fed’s goals. The FOMC meets eight times each year to set the federal funds rate. Its decisions at these meetings have a big impact on many areas of the economy, and mortgage rates are no exception.The Fed And The Federal Open Market Committee (FOMC)
Why The FOMC Adjusts The Federal Funds Rate
The FOMC uses the federal funds rate to control the money supply in the system. It may do this to help keep inflation in check when commerce begins to overheat or stimulate the economy when it slows down.
In practice, raising the federal funds rate makes it more expensive for individuals or organizations to borrow money. Lowering it makes it easier for them to engage in borrowing.
Why The Federal Funds Rate Influences Other Rates
If the federal funds rate is raised, borrowing money becomes more expensive for lenders. Money becomes less available because lenders either have to lend at a loss or raise their own short-term interest rates to make a profit on their loans.
If the rate is decreased, money becomes more readily available, and short-term interest rates sink. This can help stimulate economic activity.
Changes to the federal funds rate can impact mortgage and loan interest rates, along with interest rates on credit cards, savings accounts and certificates of deposit (CDs). In short, various loans and investments can be both directly and indirectly influenced by changes to the fed funds rate.
Federal Funds Rate Vs. Federal Discount Rate
While banks can loan each other money at the federal funds rate, they can also borrow from the Fed. However, the Fed sets a specific borrowing rate called the discount rate to discourage banks from borrowing money too heavily from them.
As a rule, the discount rate tends to be higher than the federal funds rate, making it more expensive to borrow from the Fed than from other banks. This helps steer banks toward borrowing from other lending institutions and encourage more overall activity in the system.
However, the Federal Reserve may temporarily lower its discount rate to certain banks on an emergency basis if there is a concern that a bank may need emergency credit to cover a shortfall or to keep the bank from failing altogether.
