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Federal Reserve Interest Rate: How It Works and What It Means for You

6 min read
Michelle Black By Michelle Black Updated Mar 31, 2020

When you live and work on Main Street, sometimes what happens on Wall Street — or with the Federal Reserve in New York — can seem far removed from your day-to-day life. Yet whether or not you understand Federal Reserve interest rates, the Federal Open Market Committee (FOMC), the prime rate, or monetary policy, it all eventually impacts you.

When you apply for credit (like credit cards, mortgages, or auto loans) or when you open savings accounts and invest money, the actions of the Federal Reserve can affect your personal finances.

If you don’t understand Federal Reserve interest rates (or how the Federal Reserve even works), don’t worry. You’re not alone. Many people first become aware of the Federal Reserve, or the Fed, during a financial crisis when the stock market and U.S. economy take a hit, like the Great Recession back around 2008 or the COVID-19 pandemic of 2020.

What Is the Federal Reserve?

The Federal Reserve System acts as the central bank of the United States. Congress created it in 1913 to provide the United States with a safer, more flexible, and more stable financial system. Everything the Fed does works toward the goal of creating a healthy, stable economy.

The Fed has three main parts:

  • Board of Governors: The board is based in Washington, D.C. and has seven members. The president appoints the board members and the Senate confirms them.
  • Regional Federal Reserve Banks: The Fed has 12 of these banks around the country.
  • Federal Open Market Committee (FOMC): This committee is made up of all seven members, the president of the New York Federal Reserve, and four other presidents from the remaining 11 regional banks.

What Does the Fed Do?

The Board of Governors oversees the Federal Reserve banks and helps implement monetary policy established by the FOMC.

The 12 regional Federal Reserve banks serve as operating arms of the system. They gather the economic data that helps the Fed keep tabs on the U.S. economy. The regional banks also provide input to help develop monetary policy.

The Federal Open Market Committee performs what is perhaps the most recognized function of the Federal Reserve System: It sets U.S. monetary policy. The FOMC meets regularly to evaluate the economy to determine what’s happening now and what will likely happen in the future. If you ever see a news report that the federal interest rate has changed, the FOMC is responsible.

Learn how credit card interest rates work

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What Are the Goals of the Fed’s Monetary Policy?

Congress wants the FOMC to achieve two main goals with its monetary policy — maximum employment and stable prices.

The promotion of maximum employment gives people more economic opportunities. After all, they’ll be working and earning incomes.

An environment of stable prices, on the other hand, can spur economic growth. Individuals, families, and businesses all want to know what they can expect to pay for goods and services. Stable prices make it easier for everyone to budget and plan for the future.

When instability and uncertainty exist in the economy, they can cause problems that trickle down to everyone. Business leaders, for example, tend to hold onto cash and delay investments in uncertain economic times. This can result in fewer company expansions and fewer job opportunities for the working public.

When the Federal Open Market Committee meets, it assesses the current state of the economy. It also makes projections about where the economy is heading. These factors help the FOMC set the monetary policy for the United States. This monetary policy:

  • Influences interest rates
  • Impacts the availability of money and credit

What Is the Federal Reserve Interest Rate?

The FOMC influences interest rates by establishing a federal funds rate. This interest rate is a target range, and banks charge this rate when lending money overnight to other banks.

Insider tip

The federal funds rate, sometimes called the benchmark interest rate, is not what consumers will pay to borrow money. But the fed fund rate will impact the interest rates lending institutions (like banks and credit unions) charge for consumer debt.

By influencing interest rates, the FOMC aims to maintain financial stability. Remember, instability on Wall Street (aka the stock market) and the broader financial markets can threaten not only the U.S. economy but the global economy, too.

When the FOMC meets, members decide between three courses of action:

  • Keep interest rates the same
  • Raise interest rates
  • Lower interest rates

Why Does the Federal Reserve Rate Change?

In its effort to keep prices stable, the Fed works toward an inflation rate between 2 to 3 percent.

When the economy meets expectations, the committee maintains current interest rates. In January 2020, the Federal Reserve kept the target range at 1.5% to 1.75% because the economy was moving toward a 2% inflation rate.

When the economy grows quickly, the FOMC will increase interest rates to keep inflation in check. In early 1980, the federal funds rate climbed all the way to 20% to help fight inflation.

When the economy starts to fall behind, the FOMC will decrease interest rates to kickstart economic activity. During the financial crisis of 2008, the Federal Reserve lowered the fed fund rate to 0.00% to 0.25% for the first time in an effort to stimulate the struggling economy.

Federal Reserve Cuts Interest Rates During the Coronavirus Pandemic

In early 2020, the Federal Open Market Committee was willing to maintain the fed fund rate. Yet that all changed when the coronavirus pandemic wreaked havoc on lives, lifestyles, markets, and economies.

The FOMC instituted an emergency rate cut on March 15, 2020. The committee lowered the fed fund rate to 0.00% to 0.25% — a decrease of 100 basis points.

“The effects of the coronavirus will weigh on economic activity in the near term and pose risks to the economic outlook. In light of these developments, the Committee decided to lower the target range for the federal funds rate…,” Fed officials said in a statement after cutting the fed fund rate virtually to zero.

How the Federal Reserve Interest Rates Affect You

Now that you understand how Federal Reserve interest rates work and their purpose, let’s look at how they can impact you.

When the Fed changes its benchmark interest rate, it has a rippling effect on other interest rates. The federal funds rate has an impact on the prime rate — the interest rate banks charge their best customers. While the Fed does not set the prime rate, banks often use the federal funds rate to help determine their prime rates.

Once banks determine their prime rates, it impacts other interest rates, such as those on:

Your savings accounts may also be affected, specifically how much interest banks pay you for the money you deposit.

When there is an economic slowdown, whether due to a housing crisis or coronavirus pandemic, and the Fed decides to lower interest rates, consumers might want to evaluate if it is a good time to restructure their debt.

Credit Cards

Many consumers have credit cards with variable interest rates that move up or down in the same direction as the prime rate. When the Fed cuts rates, credit card rates generally won’t be as steep. With a significant federal funds rate cut, credit card holders should anticipate lower rates as well.

Do you already avoid interest by paying off your credit card balance every month? If so, what happens with the Federal Reserve interest rates shouldn’t affect you. Your variable interest rate may decrease on your credit card, but you were already saving money by not paying that interest. (Kudos on using your credit cards responsibly!)

However, if you do revolve a credit card balance from month to month, a slight decrease in your interest rate might benefit you. If your rate indeed goes lower (it might take one or two billing cycles to find out), you should see a reduction in your interest fees. This could help you pay down your credit card debt faster.

If you owe a lot on your credit cards, applying for a balance transfer card might also be wise, providing you qualify for one. Balance transfer cards offer a low introductory rate for a certain period of time (often 6 to 18 months).

Some credit card issuers charge a fee (which could be 3 percent) to transfer your balance. But if you shop around, you can find credit cards with no balance transfer fee.

Be sure to find out how long the introductory rate applies, what the rate will be after the initial period, and if the card issuer charges any fees (balance transfer or otherwise). Good to excellent credit is your friend if you want to apply for a balance transfer card.

Mortgage Rates

When the Fed cuts rates, mortgage rates might eventually drop, too. Mortgage rates aren’t directly tied to the Federal Reserve Interest Rate. Instead, lenders look at the 10-year Treasury yield and market factors. But there have been times mortgage rates dropped based on anticipation the Fed was going to lower rates.

If you have a fixed-rate mortgage, whatever the FOMC decides won’t affect your payments. However, there could be an opportunity to benefit from an interest rate cut if you refinance your mortgage. (Again, good credit scores may work to your advantage anytime you want to apply for new financing.)

If you have an adjustable-rate mortgage, on the other hand, a drop in the target range may lower your payments. You may still want to consider refinancing your loan to a fixed-rate mortgage as well. Interest rates on loans can only go up from zero.

Before you refinance, do your homework. In order to decide whether it makes sense to refinance, make sure the total amount of repayment, including closing costs and other fees, will be less than what you’re paying under your current arrangement.

Read more

Can You Make a Mortgage Payment By Credit Card? Everything You Need to Know

Auto Loans

Auto loans are somewhat tied to the prime rate because they’re relatively short-term loans. Fixed-rate auto loans won’t change with the federal funds rate. But variable-rate auto loans could see a drop in rates, leading to lower monthly payments.

If you need a new vehicle or want to refinance your current auto loan, a low federal funds rate might work in your favor.

Parting Thoughts

A lot of what the Federal Reserve does can seem mysterious to the average person. But the moves the Fed makes with monetary policy to maximize employment and promote stable prices can impact you and your bank account.

Changes in the Federal Reserve interest rate will eventually affect what you pay when you borrow money or buy products and services.

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At a glance

The Federal Reserve Interest Rate is established by the Federal Open Market Committee (FOMC), and helps determine the interest rates charged by lenders like card issuers. As the federal funds rate goes up and down, the interest rates on credit cards and other financial products typically go up and down, too.

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