Interest rates dictate how much we have to pay to borrow money to buy things like houses and cars, start small businesses, and take out other loans. After a long period of very low interest rates, the federal funds rate, which banks use to set the prime rate, is rising.
We’re in a period of high inflation, which means interest rates are likely to rise even further. The current federal funds rate is 1.0%, up from 0.25% earlier this year. That seems like a huge jump, but it’s actually very low historically, which means there’s a lot of room for interest rates to climb.
How high could they go? Let’s look at the federal funds rate for the last 50 years and find out so you’re prepared to deal with any future money stress.
Federal Open Market Committee
The Federal Open Market Committee (FOMC) is responsible for open market operations (OMOs), which consists of buying and selling securities by a central bank in the open market. The FOMC is a 12-member group composed of representatives of the Federal Reserve System and Federal Reserve Banks, eight of them permanent and four rotating.
The FOMC meets eight times a year to discuss monetary policy and how to protect the economy from high inflation, slow growth, and other negative factors. The main way the FOMC controls the economy is by changing the federal funds rate to change the amount of interest depository institutions charge each other for lending money overnight.
Federal funds rate
The federal funds rate is the percent interest charged by one depository institution — an organization that can accept money deposits from the general public — for lending money to another depository institution overnight through the Federal Reserve. The federal funds rate is expressed as a percentage.
When the federal funds rate is changed by the FOMC, that changes the prime interest rate, foreign exchange rates, short- and long-term interest rates, inflation, growth, employment, the amount of money available, and other rates of money movement and economic indicators. The federal funds rate is 1% currently.
How the federal funds rate affects the prime rate
The federal funds rate is a rate that applies to government transactions on the open market. The prime rate is the lowest rate that consumers pay to borrow money for mortgages, car loans, credit cards, and other loans.
There are several layers of banks and lending institutions between the banks that obtain the federal funds rate and consumers, and all of those layers add a little bit to the amount of interest the next organization pays.
By the time it gets to a consumer, the prime rate is usually about three points higher than the federal funds rate. The prime rate is 4% currently.
Historical fluctuations
Because the FOMC meets eight times a year, it's possible for the federal funds rate to change every time the committee meets. In times of economic fluctuation, the FOMC changes the federal funds rate to attempt to stabilize the economy. It will raise the rate to try to stop inflation, and lower the rate to try to encourage growth.
Over the last 50 years, the federal funds rate has been as low as zero and as high as 20%. Let’s look at the trends by decade.
1970s: Average 7.79%
The 1970s were a time of economic turmoil, including two periods of stagflation caused by oil crises. The FMOC bounced the federal funds rate around to attempt to control inflation without tightening the money supply for long periods of time.
This strategy was controversial, and at the end of the decade, the FMOC sustained longer periods of higher interest. The average was 7.79%, but the range was 3.75% to 15.5%. That’s volatile.
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1980s: Average 10.92%
The beginning of the 1980s was spent attempting to control inflation by raising the federal funds rate, which then threw the country into recession. For the first few years of the decade, the rate bounced from 8.25% to 20%, but by the end of the decade, it had stabilized, along with the economy, to the range of 6.5% to 8.5%.
1990s: Average 5.3%
The 1990s were a much more stable decade for the economy as a whole and for the federal funds rate. When the FMOC changed the federal funds rate throughout the decade, the changes were overwhelmingly incremental changes, in contrast to the wide swings of the 1980s. The decade ended in 1999 with a moderate 5.5% federal funds rate.
2000s: Average 3.35%
The average for 2000-2008 was a low to moderate 3.35%, until the worldwide recession hit, at which point the FMOC dropped the federal funds rate to zero to combat the recession. The recession ended in 2009.
2010s: Average 1.63%
The FMOC kept the federal funds rate at zero until 2015 to encourage full recovery from the recession of 2008. From 2015 through 2019, the average federal funds rate was a very low 1.63% to encourage the growth of the economy and stronger employment.
2020-now: Average effectively zero
In 2020 the federal funds rate was 1.25%, but when the COVID-19 pandemic hit, the FMOC lowered the rate to 0.25% — “effectively zero” — to encourage the growth of the economy during the pandemic.
The federal funds rate was kept at effectively zero until March 2022, when Russia invaded Ukraine and inflation began to rise steeply in the U.S. and around the world. In March the federal funds rate was raised to 0.5%, and then in May, it was raised again to 1%.
Bottom line
Since the federal funds rate is low at only 1%, it is likely that the FMOC will raise it to attempt to rein in inflation and (hopefully) prevent a recession.
If the war in Ukraine continues and growth slows, putting us into or close to stagflation, the FMOC may respond the way it responded in 1979-1981 to combat stagflation, by raising the federal funds rate closer to 20%. That would be an extreme jump, but it is useful that the FMOC can take action to stabilize the economy when necessary.
Consumers who predict that the interest rate will go up in the future may take out loans now to lock in a lower rate or focus on paying down balances on credit cards to prevent paying more in interest when interest rates rise.
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