Trading News for Beginners – Meaning of the Federal Reserve’s Target Interest Rate
In this article, read an overview of:
- The Federal Funds Rate (FFR)
- How the FFR influences the banking sector
- How traders and investors analyse the FFR
- The Federal Reserve’s interest rate announcements
The Federal Reserve is America’s central bank and has the authority to set the Federal Funds Rate (FFR). This target interest rate influences how much US banks charge each other for overnight lending.
The FFR is part of monetary policy and influences how funds move in the financial system. The Federal Reserve decides monetary policy on the basis of the health of the US economy and has a long-term inflation rate goal of 2 percent. During periods of economic weakness, the Fed may decide to lower its FFR guidance. When the economy grows, the Fed could raise interest rates if inflation heats up too much.
When the Federal Funds Rate (FFR) is negative or low, there’s more incentive for banks to lend to consumers or businesses because the interest rate return is higher on a retail or business loan. Under those circumstances, credit becomes looser and more easily accessed. This is called economic stimulus because consumers and businesses will spend and invest more if they have more access to cash.
On the other hand, when the FFR is on the rise, banks have a better incentive to lend to each other because they perceive a lower risk in lending to another bank versus lending to a business or consumer. A higher FFR target range often means more expensive loans at the retail level, since banks use it as a basis for the interest rates they charge on their own loans to consumers and businesses. As a result, monetary tightening usually slows down consumer spending.
FOMC Interest Rate Statement
The Federal Open Market Committee (FOMC) meets eight times a year to decide on its interest rate policy. After the meeting, the FOMC issues statements like this:
“The Committee decided to raise the target range for the federal funds rate to 1‑1/2 to 1-3/4 percent and anticipates that ongoing increases in the target range will be appropriate.” (FOMC statement, 15 June, 2022).
Let’s interpret the statement to understand its underlying meaning.
‘The Committee decided to raise the target range for the federal funds rate to 1-½ to 1-¾ percent.’
First, we need the economic context. In May 2022, inflation in the US reached a 40-year high of 8.6 percent, meaning that prices for goods and services rose faster than the 2 percent inflation rate targeted by the Federal Reserve. Therefore, the FOMC decided to hike the FFR to a range of 1.5 to 1.75 percent, sending a signal to the banking sector to raise its prices for loans in the hopes of subduing demand for goods and services and slowing down inflation growth. On a side note, this could lead to price inflation in loans and a problem with the level of defaults on debt, but that’s a story for another day.
‘...and anticipates that ongoing increases in the target range will be appropriate.’
Here, the FOMC means that it will keep raising interest rates for the next few meetings until it’s appropriate to pause. In this situation, the pause would come when the inflation rate slows down.
What happens in the markets during an FOMC rate decision?
Stock market investors may or may not react to the latest interest rate decision, depending on the circumstances at the time.
During normal market conditions, when inflation is at around 2 percent and the economy is growing, interest rate decisions inform investors whether there are more potential returns in stocks or bonds. This changes when there are difficult market conditions such as weak economic growth or high inflation and investors become defensive as interest rates rise.
Traders in the Forex markets are heavily influenced by the Fed’s interest rate decisions because of the impact on the US Dollar, the world’s most-traded currency. The Fed’s decisions have the power to move the currency markets because interest rates can add or subtract from a currency’s perceived value. At the most fundamental level, the effect looks like this:
State of the economy -> Interest rate decision -> USD rises or falls against other currencies as traders buy or sell en masse before, during and after the decision goes public.
In short, the Federal Reserve’s interest rate decisions can affect investor and trader sentiment and move asset prices ranging from stocks to currencies.
Where can I find Federal Open Market Committee Statements?
The Federal Reserve publishes each monetary policy decision on its website. The statements include the Fed’s latest economic assessment and are well-worth reading for anyone who is interested in the financial markets.
This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.