What Rates Does the Fed Set?
The Fed has the authority to set several interest rates, but the one that has the biggest impact on much of the economy is the federal funds rate. It is, in a sense, the most fundamental interest rate in the U.S. economy.
Banking regulations require large depository institutions, which includes banks, to keep a minimum amount of cash or other capital in reserve. As customers deposit and withdraw money, a bank’s assets can fluctuate quite a bit. To avoid dropping below the minimum reserve requirement, banks often lend money to one another on a very short-term basis, often for only one day, to maintain their reserves.
The federal funds rate is the interest rate that large commercial banks charge each other for these short-term loans. It is important because it affects most other types of loans and credit that financial institutions issue. When rates are high, banks must pay more to maintain their reserves. This leads to higher rates elsewhere.
When Does the Fed Raise and Lower Rates?
The Fed might raise or lower rates because of various conditions in the economy. Raising the rate can help reduce inflation by encouraging people to save money. A higher federal funds rate means higher interest rates on savings accounts. If people put more money into savings, they spend less money, which eases inflationary pressure.
Lowering the federal funds rate can stimulate economic activity. With lower interest rates, borrowing money becomes less expensive, so people are likely to spend more. That puts more money into circulation and spurs economic growth.
The Fed has raised and lowered the federal funds rate many times over the past 50+ years. The highest the rate got after the Fed started raising the rate in 2022 was 5.33%. The rate was historically low before that, going as low as 0.08% in January 2022.
The recent highs are not that high compared to previous rate hikes. The Fed made significant increases to the rate in the late 1970s, reaching a high point of 19.04% in July 1981.
What Is the Current Rate Cut?
The first rate cut arrived on Thursday, September 19, 2024. The Fed cut the federal funds rate by 0.50%, lowering it from 5.33% to 4.83%.
What Does the Rate Cut Mean for the Economy?
A decision by the Fed to cut the federal funds rate has an impact on the economy even before it directly affects the rate that banks pay to loan money to one another. The news of an impending rate cut can lead to greater financial optimism, although it is generally prudent to wait until a rate cut actually happens before making any significant changes.
Examples of economy-wide effects of a rate cut may include the following:
- Stock market rallies
- Higher employment rates
- Increased wages
- Increased home ownership
It is also possible that only some of these effects will occur, or that none will. The decision to raise or lower the federal funds rate is based on an analysis of vast amounts of data, with no way to predict outcomes. Sometimes the Fed lowers rates because it believes the economy is doing alright, but could use a boost. Other times, it cuts rates because it believes the economy is going to get worse soon, and it wants to soften the blow.
In this particular case, the Fed has stated that the rate cut of September 19 will help continue to reduce inflation. It based the decision, it said, on positive economic indicators involving employment levels.
What Does the Rate Cut Mean for Small Businesses?
Possible effects of the Fed’s rate cut that relate to small businesses include the following:
- Small business loans: SBA loans rates may decrease as a result of the rate cut. Existing loans with variable interest rates tied to the prime rate may see rates go down as well.
- Credit cards: Credit card rates tend to go down after a rate cut.
- Investor confidence: Once money market accounts and other highly stable assets start yielding lower returns, investors often become willing to take on more risk. Small businesses might find it easier to attract investors after a rate cut.
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