First off, it’s the Federal funds rate, but we call it fed funds for short.
Secondly, it may sound complicated, but it partly sets the tone for the broader financial market (think your stock portfolio) and it’s actually not rocket science, believe it or not.
The economy needs a supply of money running through it to operate. When economic growth and inflation are low — like right now — the economy needs more juice. Interest rates are lowered.
When growth and inflation run too hot, it’s appropriate for rates to rise, restricting the availability of money and restricting economic demand and therefore restricting inflation.
So how are interest rates set? The Federal Reserve sets a target fed funds rate.
That’s the interest rate at which banks make very short term loans to each other overnight. Banks use any excess reserves they have held with the Federal Reserve. Then, banks use the borrowed funds to lend out to consumers and businesses, enabling economic activity.
The Fed can’t force a market interest rate — that’s determined by the market between the banks.
But the Fed influences rates. When the Fed wants to lower the benchmark lending rate, it buys short-term treasuries in the open market, lifting the price, which lowers the yield. The Fed is expanding the money supply and creating demand for short-term debt. When it wants to raise rates, it sells bonds, increasing supply, bringing short-term bond prices down and rates up and restricting the availability of funds to be lent.
So when the Fed lowers the effective fed funds rate, it allows more lending and more economic activity. That’s basically good for corporate revenue and earnings.
But there's more to the story. To learn the rest, see the quick video above.
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