level up: interest rates
Andy Bales - Director of Finance & Technology
"The Fed raised rates another 25 basis points"
A phrase we've been hearing every 6 weeks for a while now. How many folks actually know what it means and its implications? Here’s a quick overview:
The Federal Funds Rate ("Rates")
The Federal Funds Rate, a cornerstone of monetary policy, is set by the Federal Reserve. It represents the interest rate at which depository institutions—banks and credit unions—lend funds to each other overnight. You might wonder, why do these financial institutions even need to engage in overnight lending?
The Overnight Lending Mechanism
In the complex web of financial operations, banks and credit unions often find themselves in situations where they have either excess funds or a temporary shortfall. This is where the concept of overnight lending comes into play.
Imagine Bank A has an excess of funds that it hasn't utilized for lending or investing. On the other hand, Bank B might need additional funds to meet its reserve requirements or cover unexpected withdrawal demands. In such instances, Bank A can lend its excess funds to Bank B for a short period—usually just for the night—earning a bit of interest in the process.
This mechanism does primarily does two things
Allows banks to meet their reserve requirements (federal laws that prescribe how much cash a bank must have on hand relative to how much outstanding debt they have)
Ensures smooth operations and stability by providing liquidity in the midst their complex inflows and outflows of funds
The Result
An increase in the federal fund rate of 25bps (bps = basis points, which is really just 0.25%) reverberates throughout the entire financial system, prompting banks to recalibrate their lending rates. In practice, banks utilize the federal funds rate as a reference point for determining their own interest rates. As the cost of borrowing increases for banks due to a higher federal funds rate, they are inclined to pass on these increased costs to consumers in the form of higher interest rates on loans. This includes various loans, such as car loans, credit cards, and notably, mortgages.
In the larger context of monetary policy, the Federal Reserve employs changes in the federal funds rate to manage inflation and economic growth. Raising the rate is often used to temper rapid economic growth and prevent runaway inflation, while lowering it can stimulate borrowing and spending during periods of economic slowdown. This further underscores the indirect impact of the federal funds rate on the mortgage market, as its fluctuations are closely tied to the central bank's efforts to stabilize the economy.