“The Federal Fund Rate is the interest rate at which depository institutions lend reserve
balances to other depository institutions overnight, on an uncollateralized basis.”
What the f*ck?
Yeah.
I don’t get it either.
Hello everyone, Thought Monkey here.
Today we’re going to explore the topic of the federal fund rate.
What it is and what happens when it’s raised or lowered.
Ok.
First what is an interest rate?
An interest rate is a percent of a loan that is given out which is charged to the person
or institution borrowing money.
So for example if Bob wants to buy a house and takes out a loan of 100,000 dollars from
Wells Fargo Bank, Wells Fargo may charge him an extra 5% of that $100,000 dollars to take
the loan out - meaning that Bob actually owes the bank $105,000.
The federal interest rate – also known as the federal fund rate – is the interest
rate that banks charge each other for taking out overnight loans to meet their reserve
requirement.
The reserve requirement is something made by the Fed that tells banks how much money
they have to keep in their reserves.
It’s usually about 10% of all deposits that bank customers make.
So for every $100 dollars you deposit into your Bank of America account, B-of-A must
only hold on to $10 dollars of it.
What happens to the other $90?
This is how banks make their money.
They lend that money out to customers who may be looking for a new house, tuition for
college, a new car or even to other banks and sometimes even to the government.
Of course they charge interest rates on the money that you’ve given to them to lend
out and they make money on your money.
So what happens when a bunch of customers go to the bank and want a lot of money and
the bank doesn’t have enough in its reserves to give it out?
Well, when this happens banks can borrow money from the Fed or other banks that hold their
reserves at the Fed.
If the borrowing bank borrows from the Fed they are charged something called the discount
rate - which is the same thing as an interest rate.
If the borrowing bank borrows from another bank that keeps its money at the Fed it’s
called the Federal Funds Rate – again the same thing as an interest rate.
So let’s say Wells Fargo runs out of money today because so many of its customers want
to buy the new Call of Duty game that came out.
Wells Fargo then will borrow money from another bank, say Bank of America, and be charged
whatever the Federal Funds Rate is.
Theoretically Wells Fargo will have to pay B-of-A back at the given interest rate.
So what happens when the Fed raises or lowers its rates?
You hear about this in the news all the time and see news anchors freaking out about it
on the regular.
But why?
When the Fed raises its rates it’s usually because it’s afraid of inflation – which
is when prices increase while the value of money decreases.
For example let’s say a pack of gum costs $1 today but inflation is occurring at 10%
annually.
In one year that same pack of gum will cost $1.10.
You see, after inflation your dollar can’t buy the same pack of gum.
Some may think that when the Fed raises its rates it has a direct effect on the stock
market.
But that’s not the case.
The rate simply makes it more expensive for banks to borrow money from the Fed or from
each other.
Of course, this creates a ripple effect which influences businesses, people and the stock
market.
Banks will now charge people more to borrow money – so for example mortgages and car
loans become more expensive – which decreases the amount of money people have and affects
businesses because people will spend less of their hard earned dough.
Businesses are affected similarly – borrowing money becomes more expensive and limits business’
potential growth.
Further down the ripple the stock market is also affected.
When companies are seen as cutting back on its growth spending or are making less profit
their stock prices generally drop.
If enough companies experience this kind of decline then the entire stock market will
go down.
Ok.
What about when the Fed lowers its rate?
Well when the fed thinks the economy is in the gutter and needs some stimulating it often
releases a statement saying its objective is to lower the Federal Funds Rate.
To do this, the Fed simply lowers the discount rate – the rate at which banks may borrow
from the Fed – which pressures banks to lower their own Federal Fund Rate – the
rate at which banks may borrow from each other – in order for the Fed to meet its target
rate.
Basically when rates are lower, the Fed is trying to increase the supply of money by
making it cheaper to obtain in the hopes that institutions, banks and people will spend
it and hopefully this will stimulate the economy.
So when the economic crises hit in 2008, among many other things, the Fed lowered its rates
to encourage the economy to rebound.
So there you have it.
What the Federal Interest Rate is and what happens when rates go up or down.
Thanks for watching!
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