What does it mean when the Federal Reserve changes interest rates and why is it important?
The most educational thread you will see on your timeline today:🧵
The most educational thread you will see on your timeline today:🧵
1. By definition:
“The Federal Funds Rate is the interest rate at which depository institutions lend reserve balances to other depository institutions overnight, on an uncollateralized basis.”
Okay so that is the scientific jargon. What about the version we can understand?
“The Federal Funds Rate is the interest rate at which depository institutions lend reserve balances to other depository institutions overnight, on an uncollateralized basis.”
Okay so that is the scientific jargon. What about the version we can understand?
2. First, what is an interest rate?
An interest rate is a percent of a loan that is given out charged to the person or institution borrowing money.
An interest rate is a percent of a loan that is given out charged to the person or institution borrowing money.
3. For example if you wanted to buy a house and took out a loan for $100,000 from your bank...
The bank is going to charge you around 6.47%/yr on that $100,000 to take the loan out.
Meaning after 1 year you owe the bank $106,470.
The bank is going to charge you around 6.47%/yr on that $100,000 to take the loan out.
Meaning after 1 year you owe the bank $106,470.
4. The Federal funds rate is the interest rate banks charge each other for overnight loans to meet their reserve requirement.
The reserve requirement is the amount the Fed tells banks they have to keep in their reserves.
By the way the current number is 0%....
The reserve requirement is the amount the Fed tells banks they have to keep in their reserves.
By the way the current number is 0%....
6. For every $100 dollars you deposit into your Bank account. The Bank can do whatever they want with it.
What happens to the money?
The bank lends your money out to customers looking for a loan.
They charge interest rates to the customer and that's how they make their money.
What happens to the money?
The bank lends your money out to customers looking for a loan.
They charge interest rates to the customer and that's how they make their money.
7. What happens when customers want their money and the bank doesn’t have enough in its reserves to give out?
When this happens banks borrow money from the Fed or other banks that hold their reserves at the Fed.
When this happens banks borrow money from the Fed or other banks that hold their reserves at the Fed.
8. If your bank borrows from the Fed they are charged the discount rate.
If your bank borrows from another bank that keeps its money at the Fed it’s called the Federal Funds Rate.
The difference is in the % of the interest rate but not a whole lot different.
If your bank borrows from another bank that keeps its money at the Fed it’s called the Federal Funds Rate.
The difference is in the % of the interest rate but not a whole lot different.
9. If bank A is short on money because they've had an influx of withdrawals...
Bank A will borrow money from Bank Z.
Bank Z will charge Bank A the Federal Funds Rate as interest on the principal amount Bank A borrowed.
Bank A will borrow money from Bank Z.
Bank Z will charge Bank A the Federal Funds Rate as interest on the principal amount Bank A borrowed.
10. The Fed raises rates to help tame inflation.
Inflation is when prices rise while the value of money falls.
Inflation happens when there is an imbalance of supply and demand.
Inflation is when prices rise while the value of money falls.
Inflation happens when there is an imbalance of supply and demand.
11. The current yearly inflation number is 8.3%
That means the same goods that cost you $100 last year... now cost you $108.30
That means the same goods that cost you $100 last year... now cost you $108.30
12. Right now there is a supply chain shortage.
The idea is that by the Fed raising rates it decreases demand. Leveling Supply & demand back out.
Raising rates makes borrowing money more expensive for the banks.
This creates a ripple effect throughout the economy.
The idea is that by the Fed raising rates it decreases demand. Leveling Supply & demand back out.
Raising rates makes borrowing money more expensive for the banks.
This creates a ripple effect throughout the economy.
13. Because banks have to pay more, they charge more to people taking out loans. (Think, Mortgages/Car loans)
People paying more means they have less to spend.
Less spent by people means less revenue for businesses.
People paying more means they have less to spend.
Less spent by people means less revenue for businesses.
14. Higher rates also means borrowing money for businesses is more expensive too. Limiting potential growth.
Less revenue + more expensive borrowing for companies = Stocks tend to fall
When enough stocks fall --> Retirement accounts drop
That is where the concern comes from
Less revenue + more expensive borrowing for companies = Stocks tend to fall
When enough stocks fall --> Retirement accounts drop
That is where the concern comes from
15. This all works the other way too.
As the supply chain gets back to normal the Fed can choose to cut rates. Maintaining a balance between supply & demand.
The goal of cutting rates is to make money cheaper to get. With the hope people will spend it to stimulate the economy.
As the supply chain gets back to normal the Fed can choose to cut rates. Maintaining a balance between supply & demand.
The goal of cutting rates is to make money cheaper to get. With the hope people will spend it to stimulate the economy.
16. In recession periods, often the Feds answer is to lower rates to stimulate the economy.
But they used that card in 2020.
This year rates were already low and inflation got out of control, bringing us to an interesting situation now.
But they used that card in 2020.
This year rates were already low and inflation got out of control, bringing us to an interesting situation now.
That's all for today's thread!
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