After more than four years of increased interest rates, the Federal Reserve (the “Fed”) recently made a small rate cut, stating that more interest rate cuts may be coming soon. The Fed’s authority to raise and lower interest rates is limited to a small number of interest rates, but those rates affect countless other interest rates. This means that a change in the rates set by the Fed can affect credit cards, business loans, home mortgages and more. The Fed’s rate increases in 2022 and 2023 made other rates go up and rate cuts will make rates go down, but it could take time for the impact to reach everywhere in the economy. This article will discuss what rates the Fed can set, why it might raise or lower rates and what impact it can have on the economy in general and small businesses in particular.
The Fed has the authority to set several interest rates, but the one that has the biggest impact on much of the economy is the federal funds rate. It is, in a sense, the most fundamental interest rate in the U.S. economy.
Banking regulations require large depository institutions, which includes banks, to keep a minimum amount of cash or other capital in reserve. As customers deposit and withdraw money, a bank’s assets can fluctuate quite a bit. To avoid dropping below the minimum reserve requirement, banks often lend money to one another on a very short-term basis, often for only one day, to maintain their reserves.
The federal funds rate is the interest rate that large commercial banks charge each other for these short-term loans. It is important because it affects most other types of loans and credit that financial institutions issue. When rates are high, banks must pay more to maintain their reserves. This leads to higher rates elsewhere.
The Fed might raise or lower rates because of various conditions in the economy. Raising the rate can help reduce inflation by encouraging people to save money. A higher federal funds rate means higher interest rates on savings accounts. If people put more money into savings, they spend less money, which eases inflationary pressure.
Lowering the federal funds rate can stimulate economic activity. With lower interest rates, borrowing money becomes less expensive, so people are likely to spend more. That puts more money into circulation and spurs economic growth.
The Fed has raised and lowered the federal funds rate many times over the past 50+ years. The highest the rate got after the Fed started raising the rate in 2022 was 5.33%. The rate was historically low before that, going as low as 0.08% in January 2022.
The recent highs are not that high compared to previous rate hikes. The Fed made significant increases to the rate in the late 1970s, reaching a high point of 19.04% in July 1981.
Curious about how 2025 tax changes will affect you? Read more here
The first rate cut arrived on Thursday, September 19, 2024. The Fed cut the federal funds rate by 0.50%, lowering it from 5.33% to 4.83%.
A decision by the Fed to cut the federal funds rate has an impact on the economy even before it directly affects the rate that banks pay to loan money to one another. The news of an impending rate cut can lead to greater financial optimism, although it is generally prudent to wait until a rate cut actually happens before making any significant changes.
Examples of economy-wide effects of a rate cut may include the following:
It is also possible that only some of these effects will occur, or that none will. The decision to raise or lower the federal funds rate is based on an analysis of vast amounts of data, with no way to predict outcomes. Sometimes the Fed lowers rates because it believes the economy is doing alright, but could use a boost. Other times, it cuts rates because it believes the economy is going to get worse soon, and it wants to soften the blow.
In this particular case, the Fed has stated that the rate cut of September 19 will help continue to reduce inflation. It based the decision, it said, on positive economic indicators involving employment levels.
Possible effects of the Fed’s rate cut that relate to small businesses include the following:
If you have any questions or would like additional information about anything mentioned, please comment below or email us at askus@lgt-cpa.com