Federal Funds Rate and Its Impact on the Economy Assessment Answer

Federal Funds Rate

It is the rate at which the bank lends money to another bank on an overnight basis. Generally, the credit is given by the banks with excess cash in their reserves to the banks which need urgent cash to balance their reserve requirements. The rate of interest is determined between the two banks through mutual negotiation. Essentially, the “Federal Open Market Committee (FOMC)” determines the required federal fund rate by analysing the market situation. The weighted average rate which is determined during the negotiations is known as the effective federal funds rate. This rate is generally determined by the market but can be influenced by the Fed through its open market operations when required. 

Functions of Federal Funds Rate 

The Federal Fund Reserve has a significant impact on the economic condition, and it is determined according to the prevailing market situation to prevent the economy from the adverse effects of inflationary or deflationary pressure.

At times when the recession is predicted or prevailing in the market, the Fed initiates its open market operation for buying the securities from the market so that more money can be injected into the economy. The banks and FOMC aims to lower the Federal Fund Rate so that they can offer more loans at a lower rate of interest to the businesses and consumers. The strategy of providing cheaper helps in increasing the purchasing power of the people and boosts economic activity. Thus, a low fed rate helps the economy to overcome the recessionary pressure.

Conversely, the Federal Fund rate functions in opposite direction during inflation and when the Fed has predicted that the economic activities are going in the direction of rapid price rise. To control the inflationary pressure, the Fed sells the securities in the market to absorb excess liquidity from the economy. At this time, FOMC raises the Federal fund rate to make credit expensive at a higher rate of interest and contract the ability of banks to lend money. Raising the fund's rate helps to curb excess demand and correct inflationary pressures in the short run. 

Ripple Effects of the Increase in the FFR on the US and the World Economy 

The FOMC has raised the Fed fund rate from 0.25% to 0.50% in March 2022 for taking a move in response to inflationary signals. The increase in the fed funds rate typically increases other rates of interest throughout the world economy 

1. An increase in the Fed fund rate has its ripple effects on other rates also including the prime rate which is significantly influenced. The prime rate is the prevailing rate of interest at which consumers get loans from the banks. The increase in prime rate directly influences banking activities in terms of consumer rate of interest including credit cards, deposits, bank loans, and mortgages. 
2. The increase in the Fed fund rate also affects “the London Interbank Offered Rate (LIBOR)” which is used by the international banks to determine the rates on “adjustable-rate mortgages (ARM)”.
3. The higher rate of interest will have a positive impact on the investors as it yields higher returns on bonds and other securities. 
4. Due to the rise in the fed fund rate, the stock market will face a negative ripple effect. When the Fed rate is raised it makes borrowing expensive and also raises the cost of business for both public and private sectors.
5. While the higher rate of interest will harm the borrowers as the fed fund rate will influence the bank's rate of borrowing globally and led the banks to raise their lending rate. 

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