The federal funds rate: What it is and how it affects your wallet

The Federal Reserve sets the federal funds target rate, the interest rate at which commercial banks lend to each other overnight.

The Federal Reserve raises the fed funds rate to cool down inflation. In an ideal scenario, higher borrowing costs discourage consumers from spending money. That prompts sellers to lower prices and overall inflation to subside.

However, slowing economic activity can lead to rising unemployment and even a recession. When that happens, the Federal Reserve needs to give the economy a boost, so it may lower its target rate to encourage more spending.

Federal regulations require financial institutions to maintain a minimum amount of reserves, but because banks don't earn any interest on that money, they try to keep as little as possible. One way they do that is by lending money to other banks that have less than the mandated minimum.

When they do, the interest rate on these loans is determined by the Federal Reserve. The 12-member Federal Open Market Committee (FOMC) meets eight times a year to set its target interest rate, known as the federal funds rate.

Depending on the state of the economy, the FOMC will adjust the rate to make borrowing more or less expensive.

When the Fed raises the target rate, banks increase interest rates, making credit more expensive and savings accounts more lucrative. Lowered rates, on the other hand, have the opposite effect.

Paying attention to the federal funds rate can help consumers make smart financial decisions. When the range is reduced, you may want to consider financing a car or other large purchase. When the fed fund rate is increased, it's a better time to put money in a high-yield savings account.

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