What’s Going on With Federal Interest Rates (and How Do They Work)?

By Ellevest Team

The Fed may not be ready to celebrate any victories in the fight against inflation, but they’re not yet compelled to raise interest rates any higher either. After their latest meeting, policymakers have left interest rates unchanged at 5.5% — the highest level they’ve been in 22 years. 

But that doesn’t mean there isn’t one more interest rate hike in store for us before the end of the year. Although their outlook is optimistic, there’s still a likelihood they’ll raise interest rates by another 0.25% at their next meeting. "Recent indicators suggest that economic activity has been expanding at a solid pace. Job gains have slowed in recent months but remain strong, and the unemployment rate has remained low. Inflation remains elevated,” the Fed said in their official statement.

Wait … back up. What are “interest rates” and how do they work? And what does this recent change mean for you? All good questions. Here’s what you need to know.

A woman sitting on a stack of coins, with a line chart, % sign, and arrows in the background. Illustration.

What people mean when they talk about “interest rates”

Usually, they’re talking about the target federal funds rate, aka the fed funds rate, aka “short-term interest rates.”

What’s the federal funds rate?

By law, banks that accept deposits from people are required to keep a certain amount of cash on hand so people can withdraw money. That amount is called their “reserve requirement,” and it’s based on a percentage of the total amount of money that people have deposited at that bank.

But the amount of cash a bank has on hand changes as people go about their business depositing and withdrawing their money. If, at the end of the day, a bank thinks they’re going to have more cash on hand than they need to fulfill the reserve requirement, they can lend some of their extra to another bank who thinks they’re going to come up short. The interest rate banks charge each other on these loans is called the federal funds rate.

The Fed sets a “target” rate

Eight times a year, the Federal Open Market Committee (FOMC) — a group of people from the Fed in charge of setting monetary policy — gets together to decide what the ideal federal funds rate should be, based on how healthy the economy is (more on this in a minute). They can also meet outside their regular eight-meeting schedule if the economy is volatile.

But the FOMC can’t just dictate how much banks can charge each other; that happens via negotiation between the two banks in question. So instead, the FOMC sets a target federal funds rate between a certain range.

The actual rate banks end up charging one another is called the effective federal funds rate. In order to get that into the target range, the FOMC either adds money into the financial system, which increases supply and lowers the effective rate, or they take money out of the system, which decreases supply and increases the effective rate.

How the federal funds rate affects you (and the economy)

The federal funds rate affects how much banks pay to borrow and lend, and so it impacts how much they charge you for other financial products and causes a ripple effect on other interest rates you might encounter in daily life. That’s what makes it a useful tool for the Federal Reserve when it comes to influencing the health of the economy.

Lower rates give the economy a boost

Typically, when the federal funds rate decreases, so do the interest rates paid out on saving products, like savings accounts and certificates of deposit (CDs). But it also tends to lower the interest rates you’ll pay for debt products, like automobile loans, personal loans, and credit cards.

This makes it less worthwhile to save money, and more worthwhile to borrow money, which encourages people to save less and spend more. So when the economy needs some help, the Fed can lower rates to boost economic activity (aka spending). That’s why the Fed lowered rates to zero in March 2020 (and kept them low for so long).

Higher rates help curb inflation

It works the other way, too: When the federal funds rate increases, so do the interest rates you can earn on things like savings accounts, and the ones charged for things like loans and credit cards.

This makes it more worthwhile to save money, and less worthwhile to borrow money, which encourages people to save more and spend less. So when the economy seems like it’s growing too fast, which can lead to inflation (sound familiar?), the Fed can raise rates to slow economic activity.

What this news tells us about the future

For two full years, the federal funds rate was set at 0% to help the economy through the COVID-19 pandemic. But then inflation spiked — and stayed elevated. Plus, the job market was still abnormally hot. So over the past year, they’ve bumped rates up to 5.5% — at record speeds. Finally, inflation has been slowly cooling off, although progress has been hindered by the rise in gas prices. Job growth is still strong but showing signs of a slowdown. 

So they’re holding off on another interest rate hike — until their next meeting. Any additional hikes will be nominal, to encourage a soft landing and keep us out of a recession. While they’d hoped, originally, they’d be able to bring interest rates back to 4.6% in 2024, they’ve readjusted expectations to 5.1% given the current trajectory. 

"I've always thought that the soft landing was a plausible outcome, that there was a path to a soft landing," Fed President Jerome Powell said in a press conference. "Ultimately, this may be decided by factors that are outside of our control."

(Psst: If you’re wondering what you can do now to prep for a potential economic downturn, we’ve got you.)

Here’s what that probably means for you.

You might earn a little more on savings

Many savings accounts’ interest rates are closely tied to the target federal funds rate, because the federal funds rate is the amount the bank earns on your deposits. If interest rates go up, that typically means banks are making more money on interbank loans. 

So there’s a chance you could see the interest rate you earn on your deposits go up, especially if you have a high-yield savings account. (And the more the Fed raises rates, the more likely that will be.)

You might pay more for debt

Higher interest rates make debt more expensive. The amount you pay for variable-rate credit cards, loans, and mortgages will probably increase. And it could become more expensive to take out new loans with fixed interest rates (mortgages, refinancing your student loans, taking out a home equity line of credit, etc.). In fact, a lot of lenders have already raised prices in anticipation of this change.

Still, with more rate hikes planned later this year, it’s probably not a bad idea to try to put a little extra toward your debt now, if you can. And if you’re considering taking out a new loan or mortgage, you might think about trying to lock that in now, too.

The bottom line on interest rates

TL;DR: Rates go down: borrowing good, saving bad (or less attractive, anyway — saving is never bad). Rates go up: saving good, borrowing … not so much. With inflation being what it is, this rate increase could help cool things off. But as always, it’s impossible to know for sure what will happen next.

That’s why, at the end of the day, our advice is (always) this: Stay the course, keep investing, and build that strong financial wellness practice.


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Ellevest Team

The Ellevest team is working to help women reach their financial goals.