Ballard Spahr

Primer to Rate Setting

Over the past few years, the Federal Reserve, through its Federal Open Markets Committee (FOMC), has been intervening in the interest rate market in an attempt to balance inflation and employment. By now, most people understand that the Federal Reserve reviews inflation reports, employment reports, and other economic data in deciding whether to increase, maintain, or decrease rates. Here at Ballard Spahr, we wanted to drill down into what rates the FOMC changes and the collateral effects of those changes.

  • The Federal Reserve was established in 1913 by the Federal Reserve Act.
  • Per the Federal Reserve Act, the purpose of the Federal Reserve is to set monetary policy, in order to achieve “maximum employment, stable prices, and moderate long-term interest rates”.1
  • The goal of achieving employment, pricing, and rates is handled by the FOMC.
  • FOMC has eight annual meetings and mainly affects rates by setting a target range for the Federal Funds Rate.
  • Banks are required to maintain a reserve with the Federal Reserve that is equal to a percentage of the bank’s deposits. The Federal Funds Rate refers to the target interest rate that the FOMC sets for banks to charge other institutions for lending excess cash to them from their reserve balances on an overnight basis.
  • The Effective Federal Funds Rate (EFFR) is closely related to the Federal Fund Rate but is the rate at which banks actually lend excess cash on an overnight basis. The Effective Federal Funds Rate should be within the FOMC target for the Federal Funds Rate.
  • In addition to setting the Federal Funds Rate, the Federal Reserve can influence the market by quantitative easing or tightening. Usually, this is accomplished by either buying or selling treasuries.
  • When FOMC announces a new higher rate, the Federal Reserve tries to decrease liquidity by selling government bonds (quantitative tightening), thereby raising the federal funds rate because banks have less liquidity to trade with other banks.
  • When FOMC announces a new lower rate, the Federal Reserve can increase liquidity by buying government bonds (quantitative easing), decreasing the federal funds rate because banks have excess liquidity for trade.
  • Between quantitative actions and setting the Federal Funds Rate range, the FOMC hopes to influence the broader use of rates:
    • The prime rate is used for corporate and high-net worth customers and is usually about 3 percent above EFFR
    • The Secured Overnight Financing Rate (SOFR) represents overnight lending that is secured by treasury securities while the EFFR is an unsecured rate. SOFR is correlated with but usually lower than EFFR because SOFR is a secured rate.
    • Prime and SOFR are the main lending rates in the United States and actions that influence them tend to impact all consumer borrowing, fixed income earnings, and stock market investment.

For questions relating to rates, please feel free to contact Scott Diamond at diamonds@ballardspahr.com.

Click the image above to view the interactive graph

[1] Section 2A of the Federal Reserve Act 12 U.S.C. 225a.