Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / What the Fed Funds Rate Teaches Us About Everything
Transcript
- Lucas: The federal funds rate is 3.63 percent, and it hasn't moved in a month. But I think most people would struggle to explain what that number actually means. Luna: Right — because we hear 'the Fed raised rates' or 'the Fed cut rates,' but rarely do we stop and ask: what is this rate, exactly? Who pays it? Lucas: Exactly. So let's start with the basics. The federal funds rate is the interest rate at which depository institutions — banks and credit unions — lend reserve balances to each other overnight. It's not the rate you get on your savings account, and it's not the rate on your mortgage. But it's the anchor that pulls all those other rates along. Luna: And right now, that anchor is sitting at 3.63, which is the effective rate — the average of all those overnight loans. The Fed sets a target range, currently 3.50 to 3.75, and then uses tools like interest on reserve balances to steer the market rate into that range. Lucas: And for the listener who might wonder why we're spending an episode on this — look, if walking through the economy with us has made something click, finding a way to support the show means we can keep doing these deep dives without any commercial breaks. If today was worth a coffee to you, that's the link — buy me a coffee dot com slash fexingo. Honestly, it's how we stay independent. Luna: Yeah, it's that simple. And it lets us pick the topics that actually matter, not whatever a sponsor wants us to cover. Lucas: So back to the rate. Because here's the thing: the funds rate doesn't directly control mortgage rates or credit card APRs. It influences them through the yield curve, through bank funding costs, through expectations. When the Fed raises the funds rate, banks have to pay more for overnight money, so they tighten lending terms. That ripples out. Luna: And we're seeing that ripple right now. The 10-year Treasury yield just hit 4.65 percent — up almost 2 percent in five days. Long-term rates are moving even though the Fed hasn't touched short rates. Lucas: That's the key distinction. The funds rate is a short-term policy tool. The 10-year yield is set by the market's view of growth, inflation, and term premium. They're related, but not mechanically. And right now, the market is demanding more compensation for holding long-term debt, partly because inflation expectations have nudged up — the 10-year breakeven is at 2.26 percent, slightly higher than last week. Luna: So the Fed controls the front end of the curve, and the market controls the back end. But the front end still matters because it sets the floor for all short-term borrowing. Corporate paper, floating-rate loans, repos — they all price off the funds rate. Lucas: And here's a concrete example. Since June, the effective funds rate has been flat at 3.63. CPI has fallen from 333.98 to 332.6 — that's about a 0.4 percent decline. So real rates, adjusted for inflation, have actually risen even though the nominal rate hasn't budged. That's a tightening of financial conditions without the Fed lifting a finger. Luna: Which is exactly why the Fed can afford to be patient. They don't need to cut rates just because inflation is falling — the real rate is doing the work for them. Lucas: And yet, some Fed watchers are parsing Kevin Warsh's recent comments for clues about a shift. Warsh homed in on three phrases — I think he's trying to signal that the Fed is preparing the market for a potential cut later this year, but only if the data continues to soften. Luna: Right, but the data is mixed. Wholesale prices unexpectedly declined 0.3 percent in June, driven by gasoline. That's disinflationary. But import prices from China posted a surprise gain — the highest since 2008. So the inflation picture is not one-directional. Lucas: That's why the funds rate is such a blunt tool. The Fed can't target specific sectors. They set one rate, and it affects everything broadly. So when you have services inflation still sticky, but goods deflation happening, the funds rate can't easily fix the imbalance. Luna: Which brings us back to the basics. The funds rate is the price of central bank reserves. And reserves are the ultimate settlement asset in the banking system. When that price goes up, all funding costs adjust. That's why it's the most important number in finance, even if most people never directly borrow at that rate. Lucas: And we can see its influence in the inverted yield curve. The 2-year yield is at 4.40 percent, the 10-year at 4.65 — that's a very mild inversion. Compare that to a year ago, when the inversion was over a full percentage point. The curve is normalizing, partly because the market expects the funds rate to come down eventually. Luna: So the flat funds rate since June is actually telling us something about expectations. The market sees the Fed on hold, but pricing in cuts sometime in 2027. The futures market implies a funds rate around 3.25 percent by mid-next year. Lucas: And that expectation itself affects behavior. If companies think borrowing costs will be lower a year from now, they might delay investment. That's a headwind to growth. So the Fed's communication about the future path of the funds rate is almost as important as the rate itself. Luna: That's the Warsh playbook. He's trying to shape expectations without committing to anything. The three phrases — I think they were 'data dependent,' 'patient,' and 'prepared to adjust' — classic Fed speak. Lucas: Exactly. And the market hangs on every word because the funds rate determines the risk-free rate of return. Every asset — stocks, bonds, real estate — is priced relative to that baseline. When the funds rate goes up, the present value of future cash flows goes down. That's why stocks fell this week — the S&P 500 is down 0.2 percent in five days, the Dow down 0.5 percent. Luna: So one number, 3.63 percent, is really the center of gravity for the entire financial system. And understanding how it works gives you a framework for thinking about all the other data. Lucas: That's the takeaway. Next time you see a headline about the Fed, ask yourself: what is the funds rate doing? And what does that imply about the real rate, the yield curve, and expectations? Because that's where the story really is.