What is the federal funds rate? How does it relate to other market interest rates?

Okay, no problem. Let's talk about this seemingly professional topic in plain language.

Federal Funds Rate: The "Overnight Borrowing" Interest Between Banks

You can think of it as the interest rate banks charge each other for borrowing money.

All commercial banks in the United States have a "deposit account" at the Federal Reserve (the U.S. central bank), where they hold their reserves. By law, when banks close and settle accounts each day, the money in this account must reach a certain amount—it can't be too low.

But sometimes, after a day of business operations, some bank accounts end up with more money than required (a surplus), while others have less (a deficit). What happens then?

Banks with insufficient funds need to quickly find money to cover the shortfall.
Banks with excess funds, rather than letting it sit idle, prefer to lend it out to earn some interest.

This gives rise to an "overnight borrowing" market between them. Banks with surplus money lend it to banks with deficits, just for one night, to be repaid the next day. The interest rate for this borrowing is the Federal Funds Rate.

Please note: The Federal Reserve doesn't directly dictate, "Today, the rate must be 5.3%!" Instead, it sets a target range, for example, "5.25% - 5.50%," and then influences whether there's more or less money in the market through actions like buying and selling bonds (open market operations). This guides the actual interbank lending rate to fall within that range. What we hear in the news as "the Fed raising interest rates" or "cutting interest rates" refers to adjusting this target range.

The Ripple Effect: How It Impacts Your Wallet

The Federal Funds Rate is the "bedrock interest rate" for the entire financial market, like a stone thrown into a lake that creates expanding ripples. Its changes affect almost all market interest rates.

Thinking of it as the banks' "wholesale price" for obtaining funds makes it easy to understand:

Prime Rate
- Connection: The most direct and closest link.
- Explanation: This is the interest rate banks charge their most creditworthy customers (such as large corporations). When the banks' "wholesale price" (Federal Funds Rate) rises, their "retail price" to customers (Prime Rate) naturally follows suit. Typically, Prime Rate ≈ Federal Funds Rate + 3%.
- Impact on you: Many credit card rates, Home Equity Lines of Credit (HELOCs), and some small business loan rates are directly tied to the Prime Rate. If the Fed raises rates, your credit card interest might increase next month.
Deposit Rates (Savings & CDs)
- Connection: Positively correlated.
- Explanation: When banks can earn more interest on their loans, they are more willing to attract your deposits with higher interest, as your deposits are also a source of their funding.
- Impact on you: A Fed rate hike is good news for savers. The interest on your savings accounts, money market funds, and Certificates of Deposit (CDs) will increase, meaning you earn more on your money.
Mortgage Rates
- Connection: Indirect but strongly correlated.
- Explanation: Mortgages are long-term loans (e.g., 15 or 30 years), so they don't directly track the "overnight" Federal Funds Rate. They tend to follow the trend of the yield on the 10-year U.S. Treasury bond more closely. However, the Fed's decisions on rate hikes/cuts and future policy expectations significantly influence investor sentiment about the economy, thereby affecting long-term Treasury yields.
- Impact on you: When the Fed consistently raises rates and indicates it will maintain high rates in the future, market expectations of slowing economic activity typically lead to higher long-term Treasury yields, and mortgage rates follow suit. This means higher monthly payments if you're buying a home.
Auto Loans, Consumer Loans, etc.
- Connection: Positively correlated.
- Explanation: Similar to the logic for the Prime Rate, when banks' cost of funds increases, the rates they offer for auto loans and personal consumer loans will naturally rise.
- Impact on you: During a rate-hiking cycle, borrowing money for a car or applying for a personal loan becomes more expensive.

To summarize:

Simply put, the Federal Funds Rate is the Fed's master switch or primary lever for controlling the economy.

Rate Hike -> Banks' borrowing costs increase -> Various loan rates in the market go up -> Businesses and individuals are less willing to borrow -> Consumption and investment decrease -> Cools down an overheating economy and curbs inflation.
Rate Cut -> Banks' borrowing costs decrease -> Market rates go down -> Encourages people to borrow, consume, and invest -> Stimulates economic growth.

So, while you and I are not banks and cannot directly participate in this market, every decision made by the Federal Reserve, through these cascading ripples, ultimately affects our savings, loans, and all aspects of our daily lives.