Fed Rate Hike “Cheat Sheet:” Terms You Need to Know
A Fed rate hike is coming. But what does this really mean? Here are the key terms you need to know about interest rates and the Federal Reserve.
February 24, 2022
There is a lot of talk about inflation, changing interest rates and the Federal Reserve. But the Fed is also subject to controversy and confusion among the public.
What does the Federal Reserve actually do? We explain this in greater detail in our Federal Reserve Basics guide. To understand the interest rate environment and economic situation we are in today, it’s helpful to understand the terms often used in the financial media.
Federal Reserve and interest rates: Key terms to know
Here are the terms you need to know when it comes to the Fed, interest rates, and your money.
Federal Reserve terms
These key terms relate to the Federal Reserve itself.
The Federal Reserve
The Federal Reserve is the central bank of the United States of America. It is responsible for adjusting interest rates, managing the money supply, and setting monetary policy for the United States.
Three key system entities
The Federal Reserve consists of three key entities that operate separately, but cooperate together. The overall goal of these entities is to promote the health of the US economy, while ensuring the stability of the US financial system.
The three key system entities are:
The Federal Reserve Board of Governors (headed by the Chair of the Federal Reserve)
The Federal Reserve Banks
The Federal Open Market Committee (FOMC)
Federal Reserve Board of Governors
The Board of Governors is the governing body of the Federal Reserve. It is based in Washington, D.C.
The board consists of seven members, known as “Governors.” These members are nominated by the US President and must be confirmed by members of the United States Senate.
The Board guides the overall policy and operations of the Federal Reserve system.
The Board is headed by the Chair of the Federal Reserve. The Chairman or Chairwoman of the Federal Reserve presides over Board meetings and is the active executive officer of the entire Reserve system.
One of the seven Board members is selected by the US President to be the Chair and will serve a 4-year term. The Chair is selected by the President, but must be confirmed by the Senate.
Federal Reserve Banks
There are 12 Federal Reserve Banks, with a total of 24 branches. They are spread throughout the country, and each is responsible for its own geographical area (known as a district).
A primary function of the Federal Reserve Banks is to gather economic data from specific regions. This data is then compiled with data from other Reserve branches and used to make monetary policy decisions.
The Banks also serve as the backbone of the US financial system.
They lend to financial institutions to ensure liquidity in the financial system
They store and distribute physical currency and coins
They oversee the federal Wire Transfer and Automated Clearing House (ACH) payment system
They examine certain financial institutions to ensure compliance with federal regulations and fair lending laws
Federal Open Market Committee (FOMC)
The Federal Open Market Committee (FOMC) is a committee made up of officials from the Federal Reserve. There are 12 voting members — the seven Board of Governors members, and five Reserve Bank presidents.
The committee is responsible for reviewing economic data and financial conditions, to determine the appropriate stance for monetary policy.
A key responsibility of the FOMC is setting the federal funds rate.
The FOMC meets eight times per year to determine the target federal funds rate and discuss other economic factors. They meet in:
The current Fed meeting dates are posted online.
After each Fed meeting, “minutes” are released to the public online. Fed minutes are simply a record of everything that was discussed at the meeting.
Minutes are closely watched by the markets, as they can reveal the Fed’s plans for interest rate changes and other monetary policy decisions.
Monetary policy refers to the set of actions that a country’s central bank can perform to promote growth, stabilize markets, and control the money supply.
The overall goal of monetary policy is to keep the economy growing at a steady rate while keeping inflation within the target range.
Monetary policy officials have the power to boost the economy (often by lowering interest rates), or cool the economy if things are running too hot (often by raising interest rates).
Tightening and Easing
There are two broad directions that the Federal Reserve can move in:
“Tightening” refers to tight monetary policy, which typically means a rising federal funds interest rate.
“Easing” refers to easy monetary policy, which typically means a decreasing federal funds interest rate.
Interest rate and economic terms
These key terms explain interest rates, inflation, and other important economic concepts that are relevant to the Federal Reserve.
An interest rate is simply the amount a lender charges a borrower to take out a loan. Interest rates are expressed in a percentage amount and refer to the interest charged per year.
There are different types of interest rates:
The interest you pay on your loans or credit cards
The interest you earn on your savings account balance
The interest the Federal Reserve charges banks
The interest banks charge each other for overnight loans (Federal Funds rate)
All these different rates can lead to confusion. When you see talk of changing interest rates in the news, this is typically referring to a changing federal funds rate.
When the federal funds rate changes, this will typically trickle down into other types of interest rates. For example, a rising federal funds rate will typically lead to rising mortgage interest rates.
Inflation refers to a decrease in the general purchasing power of money, which is fueled by a rise in prices.
For instance, $5 a few decades ago could buy you a meal at a sit-down restaurant. Today, that same meal might cost $15 or $20. That $5 is the same amount of money as it was decades ago, but it simply buys fewer goods and services than it once did.
Inflation is a natural phenomenon in modern economies. However, when inflation gets too high, it can cause significant disruptions to the economy.
Target inflation rate
The Federal Reserve has a target inflation rate, which is currently 2%. This means that the goal is to keep inflation at around 2% per year.
When inflation is lower than this, the Fed may increase the money supply, drop interest rates, or use other monetary policy tools to raise it.
When inflation is higher than the target rate, the Fed may increase interest rates, decrease the money supply or use other monetary policy tools to lower the inflation rate.
Consumer price index (CPI)
The Consumer Price Index (CPI) is a common measure of inflation. It’s calculated based on the change in prices for a basket of goods and services that are commonly purchased by everyday Americans.
Instead of looking at price changes for single items, the CPI measures inflation by looking at a combination of many major spending categories (food, energy, rent, services, etc.)
Variable interest refers to a rate on a loan that can change over time. It is the opposite of a fixed interest rate, which stays the same for the life of the loan.
Variable interest rates are usually based on a benchmark rate. For instance, it might be Prime Rate + 5%. If the Prime Rate rises, variable interest rates would also rise. Credit cards are an example of a financial product with a variable interest rate.
Basis points (BPS)
Basis points, or BPS, are a common unit of measure for interest rates and percentages in finance. They may also be referred to as “bips.”
A basis point is equal to 1/100th of 1%. One basis point = 0.01%, 25 basis points = 0.25%, and 100 basis points = 1%.
Federal funds rate
The federal funds rate is set by the Federal Open Market Committee. It is the interest rate at which banks lend each other money overnight. The rate covers deposits held at the Federal Reserve (called “federal funds”).
For example, when a bank has extra liquidity (cash), it may lend it overnight to another bank with a shortfall in liquidity. The lending bank would charge the borrower the current federal funds rate.
The prime rate is a commonly used short-term interest rate for lending in the United States.
It’s primarily used as an index rate, on which total interest rates are built. For example, a bank may offer a mortgage at the prime rate + 2%, or a credit card company may extend credit at the prime rate + 15%.
The rule-of-thumb for the prime rate is:
(Federal Funds Rate + 3%) = U.S. Prime Rate
When the federal fund's target rate is 0.25%, the prime rate is likely to be 3.25%. When the federal funds rate is 2%, the prime rate is likely to be 5%.
How will changing interest rates affect me?
Changes in interest rates can have broad effects on the overall economy.
When rates are low (or decreasing), businesses and consumers tend to borrow more. Businesses borrow to build new facilities or expand operations, while consumers may borrow to buy a home and take advantage of low-interest rates.
When interest rates are high (or increasing), businesses and consumers often cut back on spending. This can lead to a slowdown of economic growth or potentially a recession at some point.
Changing interest rates can also influence inflation. If inflation is running too high, the Fed may decide to raise interest rates to slow the rate of inflation. If inflation is stubbornly low, the Fed may decrease rates to stimulate growth in the economy.
Rising interest rates from the Fed can also lead to higher interest rates paid by consumers. Increasing rates lead to higher costs for banks, which are typically passed onto consumers in the form of higher APRs on credit cards and loans.
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