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Federal Reserve policymakers this week announced a 50 basis points cut in the federal funds rate. The rate now sits at 1%, a five-year low. That's great news, right? The fact is, most consumers know little about what the federal funds rate is, and how it affects them. Here's a primer on what it means for you.
The Fed is charged with controlling monetary policy. One of the ways it controls the supply of money, and therefore factors like inflation and economic growth, is through manipulating interest rates by raising and lowering the federal funds rate.
The federal funds rate is the interest rate on money loaned between banks. Since banks must keep a certain percentage of their money in reserve, they must borrow money overnight from one another to make sure they have enough set aside. By lowering the funds rate, the Fed makes it cheaper for banks to borrow, which frees up more money that can be loaned to consumers.
When the federal funds rate rises, borrowing becomes more expensive and banks hold back more of their own money to cover the needed reserve. This leaves less money available to consumers and results in higher interest rates on everything from credit cards to car loans.
The federal funds rate is raised to fight inflation and lowered to stimulate the economy. How it affects your personal finances varies depending on the type of interest rate involved. Here's a list of different consumer rates and their likely changes due to the recent rate cut.
Unfortunately, a drop in the federal funds rate usually leads to a decline in interest rates paid on savings accounts, money-market accounts and certificates of deposit, or CDs. When banks make less on the money they lend out, they offer less on the money you lend them. If you have a fixed interest rate on a CD, for example, the federal funds rate cut will have no effect. As with consumer loans, not all banks will change their rates by the same amount, so shop around to find the best deals.