The Federal Funds Rate and The Economy
The Federal Funds Rate is the interest rate that banks charge each other for overnight loans. It affects nearly every other interest rate in the world, meaning that investors, both in fixed income and equities, pay it close attention. The FFR is manipulated by the federal reserve in order to steer the broader economy. Fed officials meet periodically to discuss economic developments and make adjustments to monetary policy.
So how do they ‘steer’ the economy? The Federal Reserve is mandated to do three things. First, they manage inflation in the economy (inflation is an overall rise in prices and is tracked by the Consumer Price Index). Second, they promote policy to maximize employment, and finally, they maintain moderate long-term interest rates. By adjusting the federal funds rate, they can influence the economy to do these three things.
The FOMC may decide to lower the Federal Funds Rate, which makes credit more readily available to businesses and consumers. Businesses now can take advantage of ‘cheap’ money (debt with a low interest rate) to fund new investment, expansions or takeovers, which leads to hiring of new employees and a drop in the unemployment rate. Additionally, consumers can borrow more money to consume more products which has a positive effect on business profitability.
But what happens when consumers and business begin borrowing too much, so that they become more likely not to pay it back and prices become inflated because of the cheap money in the system? The Fed then raises the FFR. Banks won’t loan as much money to consumers and businesses because they have to charge a higher interest rate and borrowers may not be worthy credit risks. Businesses may choose not issue debt in the public markets, leading to an overall contraction in the economy.