Every six weeks or so, talk about the Federal Reserve raising or lowering its fed funds rate heats up. So why does the central bank even move this rate?.
The federal funds rate is one of the tools the Fed has to help meet its three economic goals: Promoting maximum employment, stabilizing prices and moderating long-term interest rates, which affect the ultimate cost of financial products like mortgages.
This short-term rate serves as a benchmark for rates on borrowing and yields earned on savings for businesses and everyday Americans. It directly affects short-term interest rates and indirectly affects longer-term ones, currency exchange rates and stock prices.
Using this lever, the Federal Reserve can influence household spending, business investment, employment, production and inflation.
Why does the Fed cut interest rates?
The Fed lowers the fed funds rate to stimulate the economy by making it cheaper to borrow money. Rates on credit cards and home equity lines of credit track the fed funds rate closely and provide more spending power for Americans. Rates on other loans, such as fixed-rate mortgages, also gradually follow the general direction of the fed funds rate, giving homebuyers more purchasing power.
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Similarly, in a low-rate environment, companies can borrow money more cheaply and use those funds to grow their businesses, while boosting the overall economy.
In the wake of the Great Recession, the Federal Reserve cut the fed funds rate to effectively zero, where it remained for seven years, as it tried to help revive the economy. What followed were years of historically low-interest rates on car loans and mortgages.
Why does the Fed raise interest rates?
Four years ago, the central bank began raising interest rates gradually to return them to a more normalized level. That would give the Fed more room to cut rates if the economy slowed and went into a recession. The Federal Reserve also increases rates when inflation – or the rise in prices – becomes too high or volatile.
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When inflation is low and stable, Americans don’t have to worry that rising prices will erode the purchasing power of the money they have. Both businesses and households can also make better long-term decisions about borrowing, saving and investing.
The central bank aims to keep inflation at 2% over the long term to promote a robust economy with strong hiring and higher standards of living.