The federal funds rate is the interest rate the Federal Reserve (the Fed) allows banks to charge for lending to and borrowing from each other overnight. While the federal funds rate does not directly impact the average person, its indirect effects can be dramatic especially in today’s complicated economic times.
Inflation, unemployment, and economic instability are all seemingly interconnected concerns. Understanding the impact of a change in the federal reserve rate may reveal more about the strategy of the Fed.
How Does the Federal Funds Rate Impact the Economy?
It's important to know the effects of the federal funds rate. Namely, how does the rate impact inflation, unemployment, economic stagnation, and economic instability? When economic stagnation and/or unemployment are major concerns, the Fed may decide to lower the rate. A lower rate causes banks to charge lower rates, making it more appealing to the average person to take out loans.
These cheaper loans allow people to be more aggressive with spending, like opening a business, hiring more employees, investing, or generally spending more. Increased spending stimulates the economy, leading to growth, which in turn avoids economic stagnation and unemployment.
When high growth is a concern, the Fed may raise the rate. While growth can seem positive, it does come with some negative side effects (like inflation) if not moderated. While some inflation is good, as higher expected prices in the future incentivize people to invest more, if it gets too high, the price increases hurt consumers and businesses. This is because the prices of goods and services increase so much in a short period of time that people can no longer afford to capitalize on the economy's growth, which slows growth. Out-of-control growth also leads to uncertainty and higher-risk speculative decision-making, creating "bubbles," which can cause a crash if not controlled.
Determining the Rate
If there are no major concerns about inflation, unemployment, stagnation, or instability, the Fed may want to keep the rate at its current level.
What if multiple concerns would call for an increase and a decrease in the rate? Is one of those listed concerns more important than another, or are they all weighted the same? Scenarios where growth is low and inflation is high are often referred to as stagflation. The US has had periods of stagflation in the past, which can be used as examples to see how the Fed would react today.
The most notable example was the Oil Shock of 1973, which resulted from the OAPECs (Organization of Arab Petroleum Exporting Countries) embargo on oil to the US. Due to the embargo, already high prices, the devaluation of the dollar, and the inability of US oil manufacturers to increase production, the price of oil nearly quadrupled in three months from $2.90/barrel to $11.65/barrel, according to the Federal Reserve History site.
This happened during a time of slow growth, which when paired with increased prices, led to higher unemployment. The Fed, as a response, decided to combat inflation first. This decision likely came from the thought that even if there is some growth, it would be counterbalanced by higher prices. In addition, many of the negative effects of high inflation cause a decrease in growth. This sentiment has been echoed many times by Fed board members in recent years.
How Is the Fed Responding Now?
The Fed does not give a specific rate that is the ideal baseline. Instead, it is all relative. It decides to adjust this rate up or down depending on what is happening in the economy, with priority often given to keeping inflation in check.
The Fed started to lower rates in the second half of last year after raising them to combat the inflation caused by the high growth after recovering from COVID-19. This has been slowed partially due to concerns in the Fed of stagflation due to recent tariffs. As a result, the Fed is maintaining the current rate to see how things turn out on the trade front.
The Federal Open Market Committee met to discuss monetary policy earlier this week. The Fed generally reinforced its position of waiting for things to become clearer regarding policy before adjusting the Fed funds rate. There were also increased concerns about stagflation, though it is expected to be short-term and not extreme. These concerns are leading the Fed to maintain its current Federal Funds Rate now, with some members of the Fed wanting to have 2 rate cuts by the end of the year and others wanting to wait until 2026. We will have to wait until their next meeting at the end of July to get a clearer picture of how things will proceed.
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The material has been gathered from sources believed to be reliable, however Bedel Financial Consulting, Inc. cannot guarantee the accuracy or completeness of such information, and certain information presented here may have been condensed or summarized from its original source. To determine which investments or planning strategies may be appropriate for you, consult your financial advisor or other industry professional prior to investing or implementing a planning strategy. This article is not intended to provide investment, tax or legal advice, and nothing contained in these materials should be taken as such. Investment Advisory services are offered through Bedel Financial Consulting, Inc. Advisory services are only offered where Bedel Financial Consulting, Inc. and its representatives are properly licensed or exempt from licensure. No advice may be rendered unless a client agreement is in place.
