The federal funds rate is the interest rate at which depository institutions (banks and credit unions) lend reserve balances to other depository institutions overnight, on an uncollateralized basis. The Federal Reserve Board of Governors raised the target range for the federal funds rate to 1-1/4 to 1-1/2 percent on December 13, 2017. This increase marks the seventh time the FOMC has raised rates since it began normalizing monetary policy in December 2015. As financial conditions have improved in recent years, helps explain why the FOMC has been raising rates gradually.
Keeping rates low for too long could ignite inflationary pressures or interfere with financial stability objectives. The banking system relies on the federal funds rate as a key ingredient in its monetary policy transmission mechanism—the process by which policy actions affect spending, output, and inflation in the economy. When the FOMC alters the target for the federal funds rate, depository institutions’ cost of obtaining overnight funding changes and influences other short-term interest rates and certain longer-term interest rates. Changes in these interest rates can promote or restrain spending growth overall and thereby affect economic activity and prices, both directly and indirectly through expectations about future conditions. In addition, household and business borrowing costs fall or rise more quickly when those short-term interest rates increase or decrease more quickly than expected because borrowers typically lock in a fixed interest rate over a period of time when they obtain many types of loans. For example, banks immediately pass along changes in their funding costs through adjustments to their prime lending rate—the benchmark rate that banks charge their most creditworthy business customers—and short-term wholesale funding markets also tend to move very closely with changes in the federal funds rate. Increases in short-term U.S. dollar funding costs may prompt foreign banks to reevaluate their appetite for holding dollar assets to fund activities outside of the United States, influencing exchange rates relative to other currencies as well as global financial conditions more broadly though foreign banks’ holdings of U.S. Treasury securities provide an important offsetting force in this regard. A tightening of global financial conditions would reduce overall demand for goods and services produced in the United States and put upward pressure on U.S. Interest rates.”
In summary, by increasing the federal funds rate, it will become more expensive for depository institutions to borrow money from each other, which will be passed down to consumers in higher borrowing costs. While this may have some negative consequences such as reduced spending growth overall, it is still a necessary change that needed to happen in order to stave off inflationary pressures down the road.
