What’s Going on With Federal Interest Rates (and How Do They Work)? (2024)

If you were waiting to hear something new from the Federal Reserve at their latest meeting this month, we have some non-news: interest rates are holding steady at a 22-year-high for their fifth consecutive meeting. The decision, made unanimously, means that the range for the federal funds target rate stays at 5.25% to 5.5%.

Why? While we’ve made some progress in bringing inflation down, it hasn’t been consistent enough over the last year to warrant a change to rates. Inflation has hovered above the Fed’s target rate of 2%. In a statement, the Fed said that it “does not expect it will be appropriate to reduce the target range until it has gained greater confidence that inflation is moving sustainably toward 2%.”

But they cut a more optimistic tone on the economy, noting that, “​​economic activity has been expanding at a solid pace. Job gains have remained strong, and the unemployment rate has remained low.”

What does that mean for you? Well, first, let’s talk about what “interest rates” are and how they work. Here’s what you need to know.

What people mean when they talk about “interest rates”

Usually, they’re talking about the target federal funds rate, aka the fed funds rate, aka “short-term interest rates.”

What’s the federal funds rate?

By law, banks that accept deposits from people are required to keep a certain amount of cash on hand so people can withdraw money. That amount is called their “reserve requirement,” and it’s based on a percentage of the total amount of money that people have deposited at that bank.

But the amount of cash a bank has on hand changes as people go about their business depositing and withdrawing their money. If, at the end of the day, a bank thinks they’re going to have more cash on hand than they need to fulfill the reserve requirement, they can lend some of their extra to another bank who thinks they’re going to come up short. The interest rate banks charge each other on these loans is called the federal funds rate.

The Fed sets a “target” rate

Eight times a year, the Federal Open Market Committee (FOMC) — a group of people from the Fed in charge of setting monetary policy — gets together to decide what the ideal federal funds rate should be, based on how healthy the economy is (more on this in a minute). They can also meet outside their regular eight-meeting schedule if the economy is volatile.

But the FOMC can’t just dictate how much banks can charge each other; that happens via negotiation between the two banks in question. So instead, the FOMC sets a target federal funds rate between a certain range.

The actual rate banks end up charging one another is called the effective federal funds rate. In order to get that into the target range, the FOMC either adds money into the financial system, which increases supply and lowers the effective rate, or they take money out of the system, which decreases supply and increases the effective rate.

How the federal funds rate affects you (and the economy)

The federal funds rate affects how much banks pay to borrow and lend, and so it impacts how much they charge you for other financial products and causes a ripple effect on other interest rates you might encounter in daily life. That’s what makes it a useful tool for the Federal Reserve when it comes to influencing the health of the economy.

Lower rates give the economy a boost

Typically, when the federal funds rate decreases, so do the interest rates paid out on saving products, like savings accounts and certificates of deposit (CDs). But it also tends to lower the interest rates you’ll pay for debt products, like automobile loans, personal loans, and credit cards.

This makes it less worthwhile to save money, and more worthwhile to borrow money, which encourages people to save less and spend more. So when the economy needs some help, the Fed can lower rates to boost economic activity (aka spending). That’s why the Fed lowered rates to zero in March 2020 (and kept them low for so long).

Higher rates help curb inflation

It works the other way, too: When the federal funds rate increases, so do the interest rates you can earn on things like savings accounts, and the ones charged for things like loans and credit cards.

This makes it more worthwhile to save money, and less worthwhile to borrow money, which encourages people to save more and spend less. So when the economy seems like it’s growing too fast, which can lead to inflation (sound familiar?), the Fed can raise rates to slow economic activity.

What this news tells us about the future

As a refresher, for two full years, the federal funds rate was set at 0% to help the economy through the COVID-19 pandemic. But then inflation spiked — and stayed elevated. Plus, the job market was still abnormally hot. So over the past year, they’ve bumped rates up to the range of 5.25% to 5.5% —at record speeds. Finally, inflation has been slowly cooling off, with minimal effect on the job market, although progress has been undesirably slow.

The Fed’s goal for inflation is 2% — but it’s currently holding around 3.2%, which means there’s a way to go before they feel comfortable making cuts. “We believe that our policy rate is likely at its peak for this type of cycle, and that if the economy evolves broadly as expected, it will likely be appropriate to begin dialing back policy restraint at some point this year,” the Fed Chair Jerome Powell said in a press conference.

The Fed is now doing a delicate balancing act — keep interest rates elevated too long, and they could do some damage to the economy. But they need to keep them up long enough to rein in inflation.

The bottom line on interest rates

TL;DR: Rates go down: borrowing good, saving bad (or less attractive, anyway — saving is never bad). Rates go up: saving good, borrowing … not so much. With inflation being what it is, this rate increase could help cool things off. But as always, it’s impossible to know for sure what will happen next.

That’s why, at the end of the day, our advice is (always) this: Stay the course, keep investing, and build that strong financial wellness practice.

Disclosures