Federal Funds Rate

What It Is

The Federal Funds Rate is the interest rate banks charge each other for overnight loans of reserves. The Federal Reserve sets a target range (e.g., 5.25-5.50%) and uses open market operations to keep the effective rate within that range. It's the most important interest rate in the world.

How It Affects the Economy

• Borrowing Costs: Higher Fed Funds = higher rates on credit cards, auto loans, HELOCs, and business loans.
• Savings Rates: Higher Fed Funds = better yields on savings accounts, CDs, and money market funds.
• Stock Valuations: Higher rates increase discount rates, reducing the present value of future earnings (hurts growth stocks).
• Currency: Higher rates attract foreign capital, strengthening the dollar.
• Housing: Influences mortgage rates indirectly through Treasury yields and bank funding costs.

The Fed's Dual Mandate

• Maximum Employment: Keep unemployment low. Low rates stimulate hiring.
• Price Stability: Target 2% inflation. High rates cool inflation.
• The Fed adjusts rates to balance these sometimes conflicting goals.

Historical Context

• 1980-1981: 20%+ (Volcker crushed inflation)
• 1990s: 3-6% (normal business cycle)
• 2001: Cut to 1% (dot-com bust, 9/11)
• 2008-2015: 0-0.25% (ZIRP after financial crisis)
• 2019: ~2.5% (pre-COVID normalization)
• 2020-2021: 0-0.25% (COVID emergency)
• 2022-2024: Hiked to 5.25-5.50% (inflation fight)

Trading Signals

• Rate Hikes: Bearish for bonds, growth stocks, gold. Bullish for dollar, banks (initially).
• Rate Cuts: Bullish for bonds, growth stocks. Often signals economic weakness ahead.
• Pause After Hikes: Watch for "Fed pivot" signals. Markets often rally in anticipation of cuts.
• Emergency Cuts: Sign of crisis. Risk-off initially, then risk-on as stimulus takes effect.

Key Relationships

• 2Y Treasury: Should trade near Fed Funds expectations. Big gaps signal expected policy changes.
• Inflation (CPI): Fed hikes when inflation exceeds 2%, cuts when it falls below.
• Unemployment: Fed may cut to stimulate jobs, even if inflation is above target.