When you read or hear financial media talking about the Federal Reserve raising or lowering the interest rate, they’re generally talking about the Federal Funds Rate (FFR). This is the target range for short term interest rate that commercial banks charge each other overnight. Although the Fed sets the range, banks decide how much they want to charge one another and the average of all their negotiations is called the Effective Federal Funds Rate (EFFR).
Banks lend each other when they need liquidity to meet certain obligations like the Reserve Requirement, which is the amount of funds that a bank has to hold in reserves in case of sudden withdrawals. The Reserve Requirement is another tool at the Fed’s disposal to increase or reduce the money supply in the economy.
The range set by the FOMC (Federal Open Market Committee), which is the monetary policymaking body of the Federal Reserve System, is generally increased or decreased in increments of 25bps (basis points) like 0.00-0.25 or 0.25-0.50. In some extraordinary times they can raise or lower it by more than 25bps. The floor and the ceiling of this range is determined by the O/N RRP and the Discount Rate.
The O/N RRP (Overnight Reverse Repo) is a transaction in which the New York Fed (which is the one responsible for open market operations) sells a security to an eligible counterparty promising to repurchase it back at a specified price and time. The counterparty wouldn’t want to transact at a lower interest than the one provided by the Fed and that’s how the floor of the FFR range is maintained.
The Discount Rate is the interest rate the Fed charges commercial banks to borrow directly from it. It’s set higher because the Fed prefers banks to transact with each other and use its facility only as a last resort. So, if a bank can’t borrow from the other banks, because the interest rate charged to it is above the Discount Rate, then the bank uses the Fed’s facility. This way the ceiling is set because a bank wouldn’t want to pay more than the Discount Rate.
The FOMC meets eight times a year to set the federal funds rate and they decide if they need to adjust it based on macroeconomic factors like growth and inflation. The Fed’s mandate is price stability and maximum employment, so if the economy overheats and inflation is bound to rise above the Fed’s target of 2% inflation rate per year, then you can expect the FOMC to increase the interest rate to temper the economic activity. On the other hand, if the economy needs help to boost growth and inflation, you can expect the FOMC to lower the interest rate.
The short-term interest rate set by the FOMC directly affects things like credit card loans, saving accounts and CD rates, but it can also affect indirectly more long-term interest rates like mortgage rates. So, if you can anticipate developments in the macro space, then you can anticipate the Fed’s next move.
This article was written by Giuseppe Dellamotta.
