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Updated on Monday, April 20, 2020
The federal funds rate is a monetary policy tool wielded by the Federal Reserve’s Federal Open Market Committee (FOMC) to help regulate the economy. When the FOMC changes the federal funds rate, the rates of financial accounts change accordingly. If the Fed makes a rate cut, you’ll notice rates dropping soon after on both savings accounts and lending products.
- What is the federal funds rate?
- What happens after a Fed rate cut?
- Why the Fed cuts rates
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. It is a narrow target 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 federal funds rate influences financial institutions as they set interest rates on their lending and deposit products. This is why when the federal funds rate changes, you’ll see interest rates on financial products follow suit, including savings accounts, personal loans, mortgages and credit cards. So when the federal funds rate goes up, interest rates on financial products also go up, and vice versa when the Fed cuts rates.
What happens after a Fed rate cut?
When the federal funds rate goes down, institutions lower their rates, enabling consumers and businesses to borrow more money at lower rates. A fed rate cut means the Federal Reserve is trying to boost the economy by making money more easily accessible through lower-rate loans, thereby driving economic activity.
However, those looking for the best savings rates — including the best rates on certificates of deposit (CDs) —will be disappointed as deposit account rates fall.
How a Fed rate cut affects savings accounts
A Fed rate cut often means you can expect your savings account interest rates to drop accordingly soon after, typically at the start of the following month. This change is less common in savings accounts from brick-and-mortar banks, whose rates are already so low that their bottom line is hardly affected by a Fed rate cut.
Instead, we mostly see many online banks react, as they apparently have more room to make changes to their rates. “The average online savings account rate cut typically follows close to the Fed rate cut (most likely 25 basis points) within a month or two,” noted Ken Tumin, the founder of DepositAccounts.com.
Tumin recalls that deposit account rate cuts came quickly after the Fed cut rates in 2007. Back then, savings accounts fell to below 1%.
As you can see in the graph below, online savings accounts also began to trend downward in 2019, as a response to the Fed’s rate cut in July of that year — the first cut in over a decade. The decline in rates only sped up the following March when the Fed slashed the federal funds rate to zero (a range of 0% to 0.25%) as a response to the coronavirus pandemic.
How a Fed rate cut affects certificates of deposit (CDs)
Much like savings accounts, CD rates drop soon after a Fed rate cut, although certificates of deposit tend to follow the federal funds rate even more closely. CDs are more competitive accounts, as you lock in your money for a set period of time, and banks must be quick to respond to market changes.
An examination of historical CD rates confirms that CD interest rates drop quickly after a fed rate cut is announced. For example, amid the financial crisis, CD rates quickly followed the federal funds rate’s plunge until CD rates dropped below 2%.
Again, changes are more easily tracked in online CD rates, as the rock bottom rates typical of brick-and-mortar institutions remain more stagnant. The graph below illustrates the drastic change in CD rates’ trajectory when the Fed cut rates in March 2020.
It’s also important to keep an eye on the Fed’s future outlook for the economy and the federal funds rate to determine where CD rates may go.
“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.” That’s because, thanks to a bleak future outlook, investors don’t expect those longer-term CDs to be worth much in a few years.
How a Fed rate cut affects credit cards
While dropping rates are less welcome for deposit accounts, a Fed rate cut means you may be able to pay off your credit card bills more easily. After a rate cut, most major credit card issuers will lower their APRs accordingly within one or two billing cycles. Lowering your credit card’s variable rate means your credit card balances will accrue less in interest, possibly making it easier to pay down.
“It won’t move the needle much if [the Fed] only [cuts rates] once — since it’s [typically] only 0.25% — but any reduction is helpful when you have credit card debt,” said Matt Schulz, senior industry analyst at CompareCards.
Below, you can see the average credit card APR slowly start to make its way down from July 2019.
How a Fed rate cut affects mortgages
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, chief economist at LendingTree.
Fixed-rate mortgages, on the other hand, are less affected by the federal funds rate, instead tracking the 10-year Treasury rate. Mortgage rates also depend on other economic factors, such as inflation and the general economic outlook, since they extend over such long periods of time. You can see below that the average 30-year fixed mortgage APR was on the decline well before the Fed’s July 2019 rate cut.
Why the Fed cuts rates
The FOMC decides whether to change the federal funds rate or not at each almost monthly Fed meeting. Its decision is largely based on the economy’s performance and outlook. 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.
A fed rate hike is often used to cool down the economy and restrain inflation by tightening access to money. It also helps people save their money more efficiently in their savings accounts.
To the opposite, the Fed cuts rates when the economy needs a boost. A Fed rate cut makes money more accessible for both banks and consumers and, after months of weakening data, would hopefully breathe life back into the economy.
“A lower federal funds rate is seen as helpful to the future health of the economy,” Tumin said.