The federal funds rate is a monetary policy tool wielded by the Federal Open Market Committee (FOMC) to help regulate the economy. When the FOMC changes the federal funds rate, financial accounts’ rates change accordingly. For example, when the Fed makes a rate cut, you’ll notice savings account rates dropping soon after.
While the Fed isn’t cutting rates yet in 2020, we’re still feeling the effects of its last cut in October 2019, the third rate cut in as many meetings. Banks and other financial institutions are still adjusting their rates, although widespread cuts have softened.
What is the federal funds rate?
The federal funds rate is the Federal Reserve’s main tool for managing interest rates in the United States. Fed funds is the main benchmark for the interest rates on every financial product on the market, including savings accounts, personal loans, mortgages and credit cards.
To put it more precisely, the federal funds rate is the narrow range of interest rates at which banks and credit unions trade federal funds — the balances they hold at Federal Reserve Banks — with each other overnight. The effective federal funds rate is the weighted average of the rates that banks negotiate with each other. Financial institutions use the effective federal funds rate as the benchmark for setting interest rates on all of their other lending and deposit products.
When the federal funds rate goes up, interest rates on financial products also go up. So when the federal funds rate is high, savers rejoice because it means better returns on their deposit accounts. But it also means it’s more expensive for consumers and businesses to borrow money, putting downward pressure on economic activity and inflation, the Fed’s main enemy. It also makes it harder for borrowers to get loans when APRs are higher.
And when the federal funds rate goes down, institutions lower their rates, enabling consumers and businesses to borrow more money at lower rates, thereby driving more economic activity. On the other hand, those looking for the best savings rates, including the best rates on certificates of deposit (CDs), will be disappointed as deposit account rates fall.
What happens after a Fed rate cut?
A Fed rate cut causes a downward shift in deposit account rates. Back in July 2019, industry-wide interest rate cuts on savings and other deposit account types began almost immediately in the wake of that month’s rate reduction.
“When the Fed cuts rates, you’ll see many online banks react within a few weeks,” said Ken Tumin, founder of DepositAccounts.com, also LendingTree-owned. “Reductions in average online savings account rates usually follow close on the heels of a Fed rate cut, within a month or two.”
As for brick-and-mortar bank rates, they also see small drops, but since their rates are already so low, their bottom line will hardly be affected.
How a Fed rate cut affects certificates of deposit (CDs)
Looking at historical CD rates confirms that we can expect deposit account interest rates to drop soon after a cut is announced. Tumin recalls that the rate cuts came quickly after the Fed cut rates in 2007. This was especially true for certificates of deposit, which tend to follow the federal funds rate rather closely. Back then, amid the financial crisis, rates followed until CD rates dropped below 2%, while savings accounts were earning less than 1%.
Below, you can see how closely the average 6-month CD rate followed the federal funds rate until the chaos of the financial crisis peak.
This time around, we’ll probably see more rate cuts like we’ve already been seeing for CDs. However, it’s more important to keep an eye on the Fed’s future outlook for the federal funds rate to determine where CD rates are going.
“If the Fed paints a deteriorating picture of the economy, that will increase the odds of several more rate cuts to come,” Tumin said. “That will put more downward pressure on CD rates, especially the longer-term ones like the 3-, 4- and 5-year CDs.”
How a Fed rate cut affects your credit card and mortgage
A Fed rate cut can help you pay off your credit card bills. Most major credit card issuers will lower their APRs accordingly within one or two billing cycles.
“It won’t move the needle much if [the Fed] only [cuts rates] once — since it’s only 0.25% — but any reduction is helpful when you have credit card debt,” said Matt Shulz, senior industry analyst at CompareCards, another LendingTree-owned site. Lowering your credit card’s variable rate means your credit card balances will accrue less in interest, possibly making it easier to pay down.
A lower federal funds rate will also affect adjustable-rate mortgages and HELOCs, as they’re based on short-term rates. “These should decline in tandem with the federal funds rate,” said Tendayi Kapfidze, lead economist at LendingTree.
Fixed-rate mortgages are less affected by the federal funds rate, instead tracking the 10-year Treasury rate. “A Fed funds cut will likely have little impact on fixed mortgage rates at this point,” Kapfidze said.
Why is the Fed cutting rates?
The Fed looks closely at several factors when considering whether to raise or cut the federal funds rate, including wages, employment, consumer spending and global markets. If the data points to a strong, growing economy, when employment is high and inflation is stable, the Fed may choose to raise the federal funds rate. Again, because that tightens access to money, it tends to slow down growth and prevent overheating. It also helps people save their money more efficiently in their savings accounts.
At the moment, we’re seeing the economy continue to grow at a moderate pace. It’s nowhere close to overheating, but outside risks like slowing global growth and trade negotiations threaten its overall health. In response, the Fed has remained patient, declining to make any changes since its last cut in October 2019.
“A lower federal funds rate is seen as helpful to the future health of the economy,” Tumin said. A Fed rate cut, after months of weakening data, would hopefully breathe life back into the economy.
Note: This article includes links to DepositAccounts.com, which is also owned by LendingTree.