On Wednesday, September 18, 2024, the Federal Reserve (the United States Central Bank) Chairman Jerome Powell lowered The Federal Funds Rate. The finance world was anticipating the action of the Federal Reserve but was surprised by the size of the cut. Chairman Powell announced a half of a percentage rate reduction of the federal funds rate but, what is the federal funds rate, and what impact will it have on individuals and the economy?

The federal funds rate is the interest rate set by the Federal Reserve for short-term borrowing between banks. Due to regulation, banks were required to maintain ten percent of deposits in cash. Which means if a person deposited $100 in a bank, the bank was required to hold $10 of the $90. Being that banks are businesses and their goal is to make a profit, they could use the $90 to invest and issue loans and mortgages with the aim of making a profit. 

The purpose of the law that requires banks to hold a reserve was to eliminate bank runs. The idea is if banks hold a reserve, it will give the depositors access to their money who need it for daily activity. This activity could be going grocery shopping or paying a bill. Knowing that not all depositors require all of their money at once made the 10% reserve sufficient to meet their needs. If the bank did not have a reserve and a depositor went to withdraw some of their money and was declined due to the bank’s inability to provide access to their funds, this could lead to a panic causing more customers to storm the bank demanding their money. This has caused the collapse of many banks in the past.

As of March 2020, the banking reserve requirement has been lowered to 0%. This was a result of Covid-19. It provides more flexibility to banks during a global health crisis to provide loans to keep the economy going. This is not to say that banks are not maintaining a reserve; it just means they are not required to.

How Do Banks Maintain Their Reserves And Daily Banking Operations?

We mentioned that before the global pandemic, banks were required to maintain a 10% cash reserve in their vaults. Even though the requirement has changed, banks still need to maintain a reserve to fulfill their obligations to depositors and daily bank operations. They do this by borrowing from other banks. When banks make short-term loans to each other, there is also an interest charge. The name of this interest is called the federal fund rate because it is determined by the Federal Reserve. The Federal Reserve uses The Federal Funds Rate as a tool to increase and decrease the money supply. 

When the Federal Reserve desires to cool down the economy due to high inflation, they increase the fund rate to slow down the borrowing and lending of money in the economy. The rate was as low as 0% to 0.25% in March 2020 to help stimulate the economy. Later on due to high inflation–as high as 9.1%–in mid-2022, the Federal Reserve began its process to increase interest rates to tackle inflation. The rate was increased from 5.25% to 5.50% before the recent cut of .50%, bringing it down to 4.75% to 5.00%.

What Does This Mean For The Economy?

The Federal Reserve’s goal is to curb inflation to 2%. The inflation rate currently sits at 3%, and the Federal Reserve is planning more Fed Funds Rate cuts for the coming future. We should see interest rates on borrowing fall across the economy. This will make personal loans, car financing, credit cards, and mortgages more affordable.

Interest rates on savings accounts, CDs, and money market accounts are also likely to decrease as the Federal Reserve continues to make cuts to the Fed Funds Rate. 

FINAL THOUGHT

The federal funds rate is one of the monetary tools used by the Federal Reserve to make an impact on the economy. In times of high inflation, as we have seen in the past two years, the Federal Reserve will make an effort to gradually increase the fed funds rate to reduce inflation. Also, in times of low economic growth, as we have seen during the Covid-19 pandemic and during the 2008 recession, the Federal Reserve has lowered the Fed Fund Rate as low as 0%. It is not an exact science. Due to the complexity and sheer size of the United States economy, adjusting the fed funds rates to fight inflation or improve the economy takes careful attention.