The banking world revolves around the U.S. Federal Reserve. And banks’ interest rates revolve around the Fed’s federal funds rate, for both loans and savings.
While there is no law or equation governing how checking, savings, high yield savings accounts or certificates of deposit must align with the federal funds rate, changes to the federal funds rate cause banks and investors to adjust accordingly.
What is the Federal Funds Rate?
The federal funds rate is the interest rate at which banks lend to each other for short-term loans they may need to meet reserve requirements.
Adjusting the federal funds rate is the Fed’s primary tool for doing its official two-prong job: keeping consumer price inflation around a 2 percent target and the economy at full employment. Here’s how it works:
- Increasing the federal funds rate tends to reduce inflation and cool the economy;
- Reducing the federal funds rate tends to increase inflation and stimulate the economy.
So, if it looks as if inflation is rising above that key 2 percent level, the Fed is likely to increase the federal funds rate. But if it looks as if inflation is falling below the 2 percent level, the Fed may reduce the rate.
Periodically, the Federal Open Market Committee (FOMC) announces a new target range for the federal funds rate, based on its forecasts for the American economy. From 2015 to 2018, the Fed raised the federal funds rate several times. In 2019 it reversed course and has lowered the rate twice, with many economists predicting more rate cuts to come.
How Federal Funds Rate Changes Affect Bank Lending
Banks typically borrow funds at or near the federal funds rate and lend to customers at higher rates. The U.S. “prime” lending rate, to which many variable-rate consumer loans and mortgages are linked, is the federal funds rate plus about 3 percent.1 Thus, the interest rate on variable-rate loans will generally—and automatically—rise when the Fed raises the federal funds rate and fall when the rate is cut.
Other consumer loans, and most mortgages, are at fixed interest rates. Those rates don’t vary as the federal funds rate changes, but the interest rate on new loans and mortgages depends on the federal funds rate in force at the time the loan is made.
Why Changes in the Federal Funds Rate Affect Your Savings
Banks don’t just borrow funds from each other. In fact, most of their funding comes from you—regular people’s money deposited in checking and savings accounts and certificates of deposit.
Banks pay interest on savings accounts and CDs. However, since they can always borrow funds from each other at the federal funds rate, they don’t like to pay much above that rate for other funding sources, like customer deposits. So, when the Fed cuts the federal funds rate, banks are likely to respond by reducing interest rates on savings accounts and CDs. Sometimes, banks even cut interest rates in anticipation of a Fed rate cut.
Many CDs have fixed interest rates. When the Fed cuts the federal funds rate, existing holders of these CDs won’t be affected. However, new CDs will be likely to have lower rates of interest. Conversely, when the Fed raises the federal funds rate, existing holders of fixed-rate CDs can lose out because their interest rates don’t adjust. You can withdraw money from a CD early, but this is likely to be at a penalty cost, for example twelve months’ interest. Variable-rate CDs offer you the opportunity to benefit from rising rates, but of course if rates fall then the interest on a variable-rate CD is likely to fall too.
As a saver, it is important to remember that while variable rates fluctuate over time, one constant is that your money is safe when you deposit in an FDIC-insured bank, which provides standard insurance on your investment up to $250,000 per depositor, per account type.