Federal Interest Rate

What is a Federal Interest Rate?

The Fed sets either the federal fund rate or the discount fund rate or both. They provide cheaper or more expensive money to the markets by making money more expensive or less expensive. These two federal rates that the Fed sets are short-term rates. Very short term, as in overnight.

The Fed Funds rate is the rate banks charge one another to borrow money overnight. WHy do banks do that? Banks have certain reserve requirements that keep them liquid. If a bank makes a loan, they have to adjust their reserves at the same time. At the end of a business day if they don't have enough money in reserve they have to go borrow it...fast. They do this by borrowing from one another at deeply discounted rates.

If the Fed wants to stimulate a sluggish economy, they make money cheaper by reducing these federal interest rates. The theory is that since the money is so cheap then lenders and investors are more likely to make more loans to businesses that want to buy new factory equipment or invest in new products.

The Fed plays a role in interest rates, just not one tied to your mortgage. Instead what happens, investors anticipate future Fed moves and hope to profit from them. And when it comes to bonds, it's sometimes a situation of whether or not these investors think the economy will be white-hot with consumer demand driving up prices (which raise the federal interest rates) or stone-cold with all the money leaving the stock market and being placed in bonds, thereby driving up the bond prices and reducing interest rates.

When the Fed reduces rates, they hope to stimulate the economy. When they increase rates, they want to slow one down. The Fed looks at the overall economy and pay attention to various economic reports that may help guide them to keep the economy from overheating or going into a recession. If a report comes out that suggests the economy is gaining steeam then the likelihood of higher interest rates loom larger. Not just one report by itself, but perhaps several reports over an extended period of time. Exactly what the Fed watches is a mystery, known only to the Federal Reserve Board, but there are plenty of pundits that watch the same data and try to guess what the next Fed move might be.