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Fed funds rates – A beginners guide to how the Federal Reserve sets interest rates

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The Federal Reserve Bank of the United States is undoubtedly the central bank that the world watches. In a way, one could say that when the Fed sneezes, the global economy catches a cold.

Or so the saying goes!

But this shouldn’t come as a surprise. With the United States dollar as the world’s reserve currency, the Federal Reserve is at the very core. When the Federal Reserve or Fed for short takes a monetary policy decision, the world is attentive.

This is because there is a snowball effect.

Global economies and asset prices are influenced when the Federal Reserve changes the short-term interest rates.

The average forex trader might not be that inclined to know what’s going on in the Federal funds rate. But you can expect to see a whole new world once you start to dig in.

So, even though you might think that the Fed rates don’t affect the exchange rate of a currency as odd as the Australian dollar, it does!

In this first part of a series of articles on the Federal fund rates, we take a look at this short-term interest rates are set and how it affects the global economy.

Finally, we will take a macro approach to understand how this affects your day to day trading.

What is the federal funds rate?

The Federal funds rate is the rate set by the central bank of the United States, the Federal Reserve. The Fed sets the rate at which various institutions lend their reserve balances to each other.

Another term to depict the Federal Funds rate is the short-term interest rate or the overnight lending rate.

The lending is based on the reserves that banks must hold at the Federal Reserve Bank. Sometimes, banks can have excess reserves or fall short. This is when banks tend to lend money to each other at the rate set by the Federal Reserve Bank.

If you think that the Fed funds rate is the rate at which banks lend overnight loans to each other, then you are wrong. There is something else known as the Prime rate.

The prime rate

Banks lend to each other on a rate called the prime rate. The prime rate is of course based on the federal funds rate. When the Fed raises the Federal funds rate, the prime rates also increase.

On average, the prime rate is about 300 – 500 basis points above the Fed funds rate. Prime rates are also known as the most preferred rate. These rates are offered not just to other banks but to even some customers, depending on their credit standings.

So, if the Fed funds rate is at 2.0%, then the prime rate is about 2.3% – 2.5%.

For the rest, depending on their credit rating and history with the bank, the bank can add a spread on top of the prime interest rate. Prime rates and the Fed funds rates are important because this is where the change in interest rates starts to come in as it trickles down.

Prime rates affect both fixed and variable rates and go on further to influence the interest rate on your credit card borrowing to mortgage and even student loans.

As you can see, the Fed funds rate has a strong influence that drips down into affecting all forms of interest rates charged by the banks.

The Federal Reserve and Fed funds rate

The Fed funds rates are based on the Federal Open Markets Committee (FOMC) decision.

The central bank in the U.S. meets eight times a year to decide on the interest rates. Check out this infographic that shows the structure of the FOMC.

The decision to raise or cut interest rates depends on the central bank’s monetary policy goals.

The Federal Reserve has a dual mandate of maintaining price stability and full employment. The decision to change interest rates depends on some factors. The ultimate goal is to facilitate price stability and full employment.

For example, this article talks about how the Federal Reserve uses the Beige book to assess the economy.

How are interest rates used to affect the economy?

Interest rates are hiked when the economy is overheating. Overheating means merely when the GDP growth is rising sharply. When the economy strengthens, it creates more jobs. More jobs lead to a point when wages must increase.

When wages increase, workers (consumers) have more money in their pockets. When you have more money, you spend more.

And when you spend more, it creates demand for the goods and services.

When the demand for goods and services increase, it raises the cost of these goods and services.

To curb the excesses, the Federal Reserve controls the economy.

In times of recession, i.e., when the economy is stagnating or declining, the Federal Reserve pumps money into the market.

This is done by lowering interest rates. As the cost of borrowing declines, there is more liquidity in the market. When there is more liquidity, banks lend on lower interest rates. This is more attractive for businesses. Businesses can use the cheap lending rates to invest or finance their business activities.

This, in turn, creates more investment and more jobs.

As you can see, the cycle is interrelated and at the very center of this is the Federal funds rate.

When the U.S. central bank raises interest rates, it affects not just the economy but a whole cauldron of other things as well.

Why should you pay attention to the Fed funds rate?

We talk from an average trader’s perspective.

In most cases, when the Federal Reserve raises interest rates, it is usually done in a cycle. It is very rare to see the central bank hike interest rate in one quarter and lower rates in the next. There are instances when the central bank can pause before the next rate hike.

But typically, rate hikes and rate cuts come in cycles. To illustrate this example, we can see that the Reserve Bank of Australia or even the Reserve Bank of New Zealand is currently in a pause mode.

After lowering interest rates, both the central banks have kept rates steady.

When the Fed raises the fed funds rates, it affects almost every other currency. Of course, how these currencies react can change depending on numerous other factors.

A direct example of the impact of the Fed funds rate can be seen in the emerging markets. The recent plunge in emerging market currencies such as the Turkish lira, the Indian rupee or the Argentine peso are standing examples.

Higher borrowing cost for the U.S. dollar leaves economies vulnerable when they are reliant on foreign funding.

But come back to a trading perspective, traders will notice how other major G7 currencies behave. The euro, yen, Swiss franc and the pound sterling are some examples where you can see the market reaction.

What’s next?

So far, this article gave a brief introduction to the Federal funds rate and the prime rate. You should have a clear picture of how the Fed’s decision to change interest rates affects the global economy and price of assets as well.

In the next section, we will explore the Fed funds futures markets. This is by far, one of the most valuable resources you can use to anticipate what is happening with interest rates.

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