On September 18, 2024, the Federal Reserve announced that it cut its interest rate by half percentage point. The news quickly became financial headline worldwide.
So what is Fed’s interest rate? And why do Wall Street folks pay so much attention to it?
As United States’ central bank, Fed uses several tools for controlling the size and growth of the money supply. One of them is the Fed’s reserve requirement of its member banks. Member banks normally borrow from the Fed to increase their reserves to meet the Fed’s reserve requirements.
The rate that the Fed charges the member banks who borrow from the Fed is called “the discount rate.” Usually, most member banks would prefer to borrow funds from other banks rather than from the Fed. The interest rate member banks charge each other for borrowing is called the “federal funds rate.” This rate is usually slightly higher than the Fed’s discount rate and tends to change as the Fed’s discount rate changes.
Federal funds rate has been watched carefully as a guide to changes in other interest rates such as: bank deposit rate, mortgage rate, and auto loan, etc. It also has indirect impact on broader economy including employment, growth and inflation.
Whenever there is an increase or decrease in the federal discount rate there is a corresponding change in the federal funds rate. According to Fed, “the principal effect of an increase or decrease in the discount rate by the Fed is a corresponding change in the federal funds rate to the target level being sought by the Fed.” Hence, when we hear Fed Chairman talking about rate cut or rate increase, what he or she means is the Fed raising or lowering the target Fed funds rate range.
The current Fed’s federal funds rate target range is 4.75% – 5.00%, down by recent 0.5% cut.
Given its huge impact on financial markets worldwide, it’s not an overstatement by saying that the federal funds rate is one of the most important interest rates in the world.