You’ve probably heard of the Federal Reserve (often called “the Fed”), but do you know how its Fed Rates Fund may influence your financial decisions? According to a 2017 Nerdwallet survey, 12% of Americans don’t know what the Federal Reserve is, but they should. The Fed’s actions have an impact on interest rates, and it’s important to understand how the Fed Funds Rate fluctuations could impact your wallet.
Here’s what you need to know about the Fed, with information directly from the Federal Reserve’s website.
What is the Federal Reserve?
The Federal Reserve was created in 1913 by the Federal Reserve Act to serve as the nation’s central bank. The Board of Governors in Washington, D.C., is an agency of the federal government and reports to and is directly accountable to the Congress. This central banking system has three important features: (1) a central governing board—the Federal Reserve Board of Governors; (2) a decentralized operating structure of 12 Federal Reserve Banks; and (3) a blend of public and private characteristics. The Board provides general guidance for the Federal Reserve System and oversees the 12 Reserve Banks. It also submits an extensive report—the Monetary Policy Report—on recent economic developments and its plans for monetary policy twice a year.
Key takeaway: The Federal Reserve sets monetary policy in the U.S. Its decisions can have a direct impact on the country’s economy and your personal finances.
What is the Fed Funds rate?
The Fed Funds rate is the interest rate at which depository institutions lend balances at the Federal Reserve to other depository institutions overnight.
Changes in the Fed Funds rate trigger a chain of events that affect other short-term interest rates, foreign exchange rates, long-term interest rates, the amount of money and credit and, ultimately, a range of economic variables, including employment, output and prices of goods and services.
Key takeaway: A range of interest rates are based on the Fed Funds rate. When the rate falls, certain types of consumer loans can become cheaper to service and vice versa.
Why do interest rates matter?
One way interest rates matter is that they influence the borrowing costs and spending decisions of households and businesses. Lower interest rates, for example, would encourage more consumers and businesses to borrow money. Higher interest rates would restrain such borrowing by consumers and businesses.
The Fed seeks to set interest rates to help set the backdrop for promoting the conditions that achieve the mandate set by the Congress—namely, maximum sustainable employment, low and stable inflation, and moderate long-term interest rates. (Source.)
Key takeaway: When the economy’s struggling, the Fed lowers rates to encourage borrowing and spending. When it’s doing well, it raises them to prevent the economy from overheating.
What is inflation and how does the Federal Reserve evaluate changes in the rate of inflation?
Inflation is the increase in the prices of goods and services over time. Inflation cannot be measured by an increase in the cost of one product or service, or even several products or services. Rather, inflation is a general increase in the overall price level of the goods and services in the economy.
Federal Reserve policymakers evaluate changes in inflation by monitoring several different price indexes. A price index measures changes in the price of a group of goods and services. The Fed considers several price indexes because different indexes track different products and services, and because different indexes are calculated differently. Therefore, various indexes can send diverse signals about inflation. (Source.)
Key takeaway: The Federal Reserve monitors inflation—the rise in the price of goods—to ensure that costs don’t climb too quickly.
It’s important to understand how the Federal Reserve works, because its actions can impact your personal finances. The more informed you are about the direction of rates, the better you can budget and plan for the future.
To learn more about the Federal Reserve and the Fed Funds rate, see these resources:
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