On December 16, 2015, the Federal Reserve announced that it was raising interest rates. More specifically, it raised its target for the so-called federal funds rate. Before talking about just what is the federal funds rate, we’d like to point out what it is not:

It is not mortgage rates
It is not bond interest rates
It is not muni bond rates
It is not T-Bill rates
It is not CD rates
It is not the Prime Rate
It is not credit card rates
It is not the index on a variable rate mortgage

Most of these interest rates have actually fallen since December 16.

From our good friends at Wikipedia: The federal funds rate is the interest rate at which banks and credit unions lend reserve balances to other banks and credit unions, overnight. A “reserve balance” is a bank’s own bank account at the Federal Reserve. It’s the portion of customer deposits they must keep in reserve, to protect against risk of a bank panic. Customer deposits $100; bank puts $10 of that in the Fed for safekeeping. If a bank gets a new deposit via a customer walking in the door and depositing a check, this $10 set-aside for reserves works normally.

But sometimes banks create deposits out of thin air (if that’s a surprise to you, you’re not alone). When a bank lends a business $100, it does so by making a ledger entry of $100 into the business’ deposit account. Any $100 deposit triggers a requirement for $10 to go into the Fed. Since the business needs the full $100 (not just $90), the bank is missing the $10 reserve amount it owes the Fed. So it borrows the $10 in reserves from another bank. Another bank might have extra reserves due to one of its customers paying off a loan (among other reasons). So a $10 reserve loan is made, at a particular interest rate…

The Federal Funds Rate

In theory, if these reserve loans between banks get more expensive, borrowing banks will be reluctant to make as many new loans — and the associated “out of thin air” deposits. This will, in theory, dampen the business cycle and reduce inflationary pressures. The method by which the Fed coaxes this rate higher is not important to us here.

What is important is to realize that the Fed is not controlling any other interest rates. In fact, if its federal funds rate-raising actions work, the economy could slow down and other interest rates might fall. This happened in 2005. Then-Fed President Greenspan termed it a “conundrum” — that while the Fed was pushing up the federal funds rate, most other interest rates were falling.

 

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