The Federal Reserve, or the Fed, has recently garnered much attention for raising interest rates to combat inflation.
Inflation is bad news for everyone. Consumers face increased prices of everyday products, from food and gas to electronics. In addition, increased interest rates affect loans, making them more expensive and challenging to get, affecting both consumers and businesses.
So, what is the Federal Reserve, and how do they control interest rates?
WHAT IS THE FEDERAL RESERVE?
The Federal Reserve is the central bank of the United States. It began operating on December 23rd, 1913. The central bank was a response to a series of financial panics that resulted in the desire for central control of the U.S. monetary system to prevent and alleviate future financial crises.
Free-market economies are naturally volatile as they follow a general cycle of peaks and valleys ("booms" and "busts"). The Fed looks to stabilize and grow the system by keeping prices in check while maintaining high employment. One of the tools that the Fed uses to meet its goals is by controlling interest rates.
WHAT ARE FED FUNDS?
Fed funds are the reserves that banks keep at any 12 regional Federal Reserve Banks. Each year, the Federal Open Market Committee (FOMC) sets a target for the fed funds rate.
HOW FED FUNDS WORK
The Federal Funds Rate is the interest rate banks charge each other for overnight borrowings of excess reserves. It is the primary tool used by the Federal Reserve to influence the nation's economy.
As a critical factor in the performance of the stock market and other financial markets, the rate will affect the cost of borrowing money. For example, a higher fed funds rate means it's more expensive for investors to borrow money which can lead to slower economic growth. On the other hand, a lower rate makes borrowing money cheaper, leading to faster growth.
The FOMC, responsible for setting the nation's monetary policy, will set the fed funds rate. The committee meets eight times a year to review economic conditions while setting the target for the federal funds rate. In addition, the FOMC reviews financial data, such as inflation and unemployment, to determine the appropriate level for the fed funds rate.
In other instances, like in 2022, the FOMC increased the rate to help reduce inflation. A higher rate ultimately results in less consumer spending, thus reducing demand and slowing inflation.
However, it can also lead to businesses cutting employees, especially if an economic recession is on the horizon.
The fed funds rate is an integral part of the nation's monetary policy and can significantly impact the performance of the stock market and other financial markets. Therefore, investors need to understand the federal funds rate and how it'll affect their investments.
Although there's much skepticism around the Fed and its ability to manipulate the U.S. economy, they are still considered necessary for maintaining the economic system. Without the Fed's stability and regulation, nothing would be in place to prevent or dampen financial panics and crises. Even though increasing rates may seem like a troubling time for everyone, it still provides a strategy for promoting future economic growth and stability.
Published March 2023