The Lord of the Rates

Pretty much everyone has noticed by now that you’re not getting paid very much by your bank account. Interest rates have been at historical lows since the financial crisis, but lately are finally on the rise.

We hear a lot about the all-powerful Fed Funds Rate and how the Federal Reserve is increasing it to “tighten monetary policy”.

So, what does this mean for the average person?

The Fed Funds Rate is the rate banks charge each other for overnight use of reserves.

The lower the rate, the easier it is for banks to borrow money from each other and make loans. The higher the rate, the more caution they will use before they lend out money because it isn’t as cheap to borrow from each other.

The media falsely leads us to assume that the Fed Funds rate is directly controlling the loan rates we pay and get paid from the bank, which isn’t entirely true.

The way that the Fed effects our mortgage rates and other loans is through setting the Discount Rate. This is what The Federal Reserve charges member banks to borrow money directly from them. And this has a direct impact on a bank’s Prime Rate, which is the lending rate they give to their highest rated customers.

So, the Federal Reserve raising the Discount Rate will have a direct impact on mortgage rates. Where, the more popular Fed Funds rate has more to do with the general availability of loans.

That being said, both rates have been moving up throughout the last 3 years, limiting the availability and raising the price of loans. This is all in an effort by the Federal Reserve to control inflation and not let the improving economy get out of hand.

If all the above is gibberish to you, that’s really ok. But, having a general understanding of what the Federal reserve is actually controlling when you hear about “interest rates” on the news can help wrap your head around what’s going on in today’s economy and what actually matters to you.

We can dive more into rates on the investing side and how they’re connected to all of this later.