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Ask a Fool: What Is the Federal Funds Rate and Why Does It Matter So Much?

By Matthew Frankel, CFP® - Aug 16, 2019 at 12:00PM

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Here's the key interest rate the Federal Reserve controls, and how it affects the U.S. economy.

Q: The Federal Reserve just cut rates. What does this mean to me as a consumer and to the U.S. economy as a whole?

When you hear that the Federal Reserve "raised rates" or "cut rates," what actually happened is that the Federal Open Market Committee changed the target range of the federal funds rate.

This is the interest rate that banks charge other banks to borrow money and is the primary tool that the Federal Reserve uses to achieve its two main objectives: maximizing employment and stabilizing prices.

Without getting too deep into the mechanics of bank capitalization, a lower federal funds rate encourages banks to borrow and ends up injecting more money into the economy. Conversely, a hike in the federal funds rate makes it more expensive to borrow and effectively removes money from the economy.

In addition, there are several key interest rates that are tied to the federal funds rate. The U.S. prime rate is perhaps the most significant, as it moves up or down in tandem with the federal funds rate and is the interest rate banks charge their most qualified customers to borrow money. Other consumer interest rates are tied to the prime rate, such as credit card interest and home equity interest. And although they aren't directly tied to the prime rate, other borrowing rates (such as those for mortgages and auto loans) tend to move in the same direction.

In a nutshell, a lower federal funds rate makes it cheaper for banks, consumers, and businesses to borrow money, and therefore stimulates economic activity. A higher federal funds rate has the opposite effect.

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