Markets Explained

When It Comes To Capital Markets, What’s The Fed Got To Do With It?

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When It Comes To Capital Markets, What’s The Fed Got To Do With It?

Whenever the Federal Reserve takes action, it’s a big deal.
A recent search for “federal reserve interest rates” on Google News shows more than 30,000 articles. When the Federal Reserve changes the interest rate, individual investors need to understand the potential impact those changes have on capital markets.

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What is the federal funds rate and how does it work?

When you read about the interest rate benchmark set by the Federal Reserve, what you are likely reading about is the federal funds target rate. The Federal Reserve uses this target rate as one of its tools to influence inflation and employment. It is one of the most influential financial indicators in the world, according to Investopedia. Put simply, while the rate specifically targets overnight loans between banks, it influences the interest rates charged for all types of loans.

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What effect does a lower rate have on the capital markets?

What really matters about the federal funds target rate is that it broadly influences credit conditions throughout the economy.

In general, when the federal funds rate is low, banks can more cheaply borrow money — and that means there is more money for them to loan to someone who is looking to start a business or buy a home, a company that wants to build an office building or a firm that wants to hire more employees. Recently, the Federal Reserve has placed a strong focus on trying to influence labor market conditions by making credit more readily available. As the economy and labor markets strengthen, the Federal Reserve can be expected to begin raising its target rate at some point.

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But how does this affect me?

The federal funds target rate can have a big impact on overall activity in the capital markets and on interest rates throughout the economy. Of course, a rise in the federal funds rate can produce impacts for some savers through higher interest rates on savings accounts and certificates of deposit. However, at the same time, the rates banks charge will also rise, meaning that the cost of borrowing for consumers and businesses will also go up.

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Where is the rate now and how might it change?

Currently, the Federal Reserve is keeping the federal funds target rate between 0 and 0.25 percent. Although the Federal Reserve has recently stated that “economic conditions may, for some time, warrant keeping the target federal funds rate below levels the committee views as normal in the longer run.” Expectations are that the rate may be raised some time in 2015. At least one Federal Reserve Bank president thinks there are signs that economic growth may lead to the rate rising sooner than market expectations.