Despite the frustratingly slow journey to lower inflation, the Federal Reserve hasn’t been deterred from making another interest rate cut. At their last meeting of the year, they announced an additional cut of a quarter point, bringing it to a range of 4.25% to 4.5%. They also hinted at least two more rate cuts in the coming year — which they would consider with extreme caution.

“We decided it was the right call because we thought it was the best decision to foster achievement of both of our goals, maximum employment and price stability,” said Fed Chair Jerome Powell in his press conference. “For additional cuts, we’re going to be looking for further progress on inflation.”

While the disinflation process has stagnated, we’ve still come a long way from where we were in 2022, when inflation hit its peak at 9.1%. (The Fed’s goal, as a reminder, is a steady 2%.)

But before we get into what this all means for you, let’s talk about interest rates — what they are, how they work, and how the Fed decides what they’ll be.

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

As a refresher, for two full years, the federal funds rate was set at 0% to help the economy through the pandemic. But then inflation spiked — and stayed elevated. Plus, the job market was still abnormally hot. So they raised rates at record speeds, and over the past year, left them up to the range of 5.25–5.5%.

As inflation started to slowly cool down, the Fed began cutting rates again. But in the last few months that progress has stagnated.

"It's kind of common sense that when the path is uncertain, you go a little bit slower," said Powell. "It's not unlike driving on a foggy night or walking into a dark room full of furniture." Which means that future rate cuts should not be taken for granted. In fact, Powell didn’t totally rule out the possibility of a rate hike.

What does this mean for you? Well, outside of inflation, other areas have been slow to respond to these rate cuts — mortgage rates, for example, remain stubbornly high — but that doesn’t mean they’re not working.

“There’s tremendous pain in that burst of inflation that was very global — this was everywhere in all advanced economies at the same time,” Powell said. “The US economy is just performing very, very well — substantially better than our global peer group. The outlook is pretty bright for our economy. We have to stay on task, though.”

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. However, most consumers won’t see an immediate impact from this aggressive rate cut on their finances. Financial institutions are a lot slower to cut rates than the Fed. 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 a strong financial plan.

Disclosures