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This blog has been written keeping in mind the Federal Interest Rate Decision and how you can benefit from them.
What is the federal funds rate?
It is the interest rate at which financial institutions such as banks and credit unions lend money to others, even other banks. In simple words, it is the rate of interest at which the borrowing bank or institutions pay to the lending bank against the sum borrowed.
Typically, the interest rate is negotiated between the borrowing and lending institutions, and its weighted average across all such transactions forms the federal funds effective rate.
Federal funds rate on the rise
When the Federal Reserve makes a decision to raise the federal funds rate, it usually adds on to the worth of USD and brings down inflation.
Since June 2006, it has not increased the rate of interest and kept it close to 0%. During 2008, at the time of financial crisis, the federal funds rate fluctuated from 0% to 0.25%. Currently, the rate is varying from 1% to 1.25%.
However, it’s expected to rise in the near future.
The Federal Reserve plans to achieve the highest employment rate possible, and stabilize the domestic consumer goods prices by increasing the rate.
Why the rate changes from time to time
When the economy starts growing at a fast pace, the Federal Reserve controls the price increase by increasing the funds rate.
It motivates people to save more and spend less. This helps to reduce inflation and keep it in check.
Conversely, when recession sets in, the reserve lowers the funds rate to make goods more affordable for people to buy.
Funds rate and the US dollar
The U.S. dollar strengthens whenever the federal funds rates increase. Although an increase in average wages and overall consumption should help to increase the value of U.S. dollar, in practice the employment rate continues to remain sluggish.
Since reduced funds rates help businesses to expand in a planned and staged manner over time, it is carefully regulated. When businesses are motivated to expand their operations, it creates employment opportunities which also strengthens the U.S. dollar.
Regulating the funds rate
Inter-bank borrowings help to raise the funds rate. Financial institutions such as banks can often face time constraints while financing a big-sized business. This is because the bank might have already offered the bulk of its working capital to individual borrowers, in the form of loans, and not have any surplus left over to finance a big project.
In such cases, it might borrow capital from other banks or credit unions to honor the project. The rate of interest agreed with the lending institution might be more than the current market lending rate.
If the reserve rate were to increase, the borrowing bank would be forced to forego the project, which would mean no additional jobs opportunities are created. This is not good for the economy.
The Federal Reserve tries to regulate the inflation rate by, in turn, regulating its funds rate. It monitors the current market scenario and increases or decreases its funds rate keeping in tune with how aggressively banks and financial institutions take on new projects, and how much capital they borrow or lend.
Therefore, the Federal funds rate is a great regulatory tool to help the US economy grow freely.
Moreover, the Federal funds rates help to standardize all interest rates in the US market. It functions as a benchmark and influences the lending rates offered by banks.
It also indirectly affects long-term interest rates like savings, loans and mortgages.
Stock market investors prefer to keep in touch with the latest news from Federal Reserve to discover, and exploit investment and selling opportunities to make a tidy profit.
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