Interest Rate (Federal Funds Rate)
Definition
The rate at which banks lend to each other overnight, set by the Federal Reserve, which influences all other interest rates in the economy including mortgages, savings, and loans.
The federal funds rate is the benchmark interest rate set by the Federal Reserve's Federal Open Market Committee (FOMC). While technically the rate banks charge each other for overnight loans, it cascades through the entire economy, influencing mortgage rates, savings account yields, bond returns, and stock valuations.
The Fed raises rates to cool inflation (making borrowing more expensive slows spending and investment) and lowers rates to stimulate growth (cheaper borrowing encourages spending, investment, and hiring). This balancing act between inflation and economic growth is the Fed's primary mandate.
Interest rates affect virtually every financial decision. Higher rates mean: more expensive mortgages and loans, higher savings account and CD yields, lower bond prices (inverse relationship), potentially lower stock valuations (future earnings are worth less when discount rates rise), and a stronger dollar (attracting foreign investment seeking higher yields).
The rate environment dramatically affects investment strategy. In low-rate environments (2009-2021), investors stretched for yield in riskier assets, stock valuations expanded, and borrowing was cheap. In higher-rate environments, bonds become more attractive, cash earns meaningful returns, and highly valued stocks face pressure.
For personal finance, rate changes affect: mortgage affordability (1% rate increase on a $400,000 mortgage adds ~$250/month to payments), savings returns (rate hikes help savers), variable-rate debt costs (credit cards, ARMs), and bond portfolio values. Understanding the rate environment helps you make better financial decisions.
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Related Terms
Frequently Asked Questions
How do interest rate changes affect my portfolio?
Rising rates tend to: increase savings/CD yields, lower bond prices, pressure high-valuation stocks, and strengthen the dollar. Falling rates tend to: decrease savings yields, boost bond prices, support stock valuations, and weaken the dollar. The transition periods create the most volatility.
How often does the Fed change interest rates?
The FOMC meets 8 times per year and can change rates at any meeting (or between meetings in emergencies). Changes are typically 0.25% increments, though 0.50% and even 0.75% moves have occurred. The Fed provides forward guidance on likely future moves to reduce market surprises.