What is the Federal Fund Rate, and why should it matter to you?


Remember the financial crisis that started in 2007? Man, was that scary!

Thanks to a variety of factors including (but certainly not limited to) the housing bubble bursting and the subprime mortgage crisis, the economy tanked and took pretty much every stock with it.

Luckily, the Federal Reserve — or the Fed, America’s central banking system and governing body of our country’s economy — had a plan. They were going to lower the Federal Funds Rate to get consumer spending up, investments up, and artificially stimulate the economy.

The rate decrease worked. We’re no longer in a recession, people are investing like mad, and the economy seems to be in better shape. Since things seem to be doing well, however, the Fed wants to increase the Federal Funds Rate again, and it’s freaking people out.

The Federal Funds Rate determines the rate at which big banks can borrow from other big banks.

federal-fund-rate-1
Wikimedia Commons

How and why this works is incredibly intricate and complicated, but just know that it kinda helps determine the American economy.

The rate is lowered during times of crisis, like a recession, and increased when things are looking good again.

federal-fund-rate-2
88-Khan

Lowering the rate means consumers will be encouraged to spend more, people will borrow more money, and people will buy more houses. It forces the economy to get better, in a way.

Raising the rate means people will spend less, have a slightly harder time borrowing money, and buy less property.

federal-fund-rate-3
Flickr/American Advisors Group

Unfortunately, the rate can’t always be kept low, because that’s not a natural way to keep the economy afloat. There has to be a gradual increase over time when the economy is finally on the right track.

Since the recession, the rate has been close to zero, but it’ll be gradually increased…eventually.

federal-fund-rate-4
Flickr/Day Donaldson

Every time Janet Yellen and the rest of the Fed’s board of Governors meet to make an announcement — which they last did on September 21 — they have chosen to hold off on increasing the Fed rate. The only time they raised the rate since 2006 was last December, by .25%, an insignificant increase.

When the rate is eventually increased, interest rates will go up at banks.

federal-fund-rate-5
Flickr/Insider Monkey

This means people can put their money in savings and see their money grow more without any degree of risk.

This would inevitably mean that people would invest less on the stock market, which has a much higher degree of risk.

Flickr/TheTaxHaven

If you could get smaller but guaranteed growth on your money, or a chance to grow your money exponentially while possibly losing it all, which one would you choose?

Since the fund rate is close to zero and hasn’t really budged, the market is doing fairly well, and investors are happy.

StockTwits
StockTwits

In fact, when the Fed announced they wouldn’t increase rates on September 21, the Nasdaq reached an all-time high. It won’t stay like that forever, though.


Every time the Fed meets and makes their announcement, the chances of them raising their rate increases over time. They’re set to meet two more times this year. Only time will tell how the markets will react when the fed rate increases, though they’ve decreased at the mere hint that the rates might go up, which is plenty scary.

Share this story with your friends below. It might teach them something new!


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