Latest / Inflation Explained with Fexingo: CPI, Prices, and the Cost of Living for Everyday People / How the Fed Funds Rate Shapes Your Everyday Prices
Transcript
- Lucas: So the Fed has held the fed funds rate at 3.63 percent since January, and inflation is still running at 4.2 percent annually as of May. That gap tells you that the traditional lever — the one rate everyone watches — isn't working the way textbooks say it should. Luna: Right — because if the fed funds rate is above inflation, that should be restrictive. But here we are. Lucas: Exactly. And the reason is that the fed funds rate isn't the only rate that matters. There's this other number — the Interest on Reserve Balances, or IORB — that the Fed sets at 3.65 percent. That's the rate they pay banks on the reserves those banks hold at the Fed. Luna: So banks get paid 3.65 percent just to park money at the central bank. That's basically a risk-free return. Lucas: Correct. And it creates a floor. No bank is going to lend to another bank overnight for less than what they can get from the Fed for doing nothing. So the fed funds rate — the rate at which banks lend reserves to each other — stays close to that IORB. In practice, it's been a few basis points below. As of yesterday, the daily fed funds rate was 3.62 percent. Luna: Okay, so that's the plumbing. But what does that mean for someone who's not a bank? Lucas: It means the cost of money for regular people isn't set by the fed funds rate directly. It's set by what banks charge each other for unsecured loans — that's the SOFR, the Secured Overnight Financing Rate. SOFR has been hovering around 3.64 percent. Then banks add their own spread for credit risk, operating costs, and profit. Luna: And that spread has been widening. I saw a report that credit card APRs are averaging over 22 percent now, even though the fed funds rate hasn't moved. Lucas: That's exactly the point. The fed funds rate sets the base, but the spread is determined by banks' perception of risk. And right now, with wholesale prices surging — producer prices rose 1.1 percent in May, more than expected — banks see higher input costs ahead. They're preemptively raising rates on consumers. Luna: So the inflation we're feeling in credit card payments and auto loans isn't really about the fed funds rate. It's about banks repricing risk. Lucas: Exactly. And the data backs that up. The effective fed funds rate has been flat for months. But the spread between that rate and what consumers pay on new car loans has expanded by about 40 basis points since January. That's not the Fed — that's banks saying, 'We think the economy is riskier than it was.' Luna: Which brings us to small businesses. They don't get the same rates as big corporations. They're paying SOFR plus maybe 300 basis points on a line of credit. That's a huge drag. Lucas: And that cost shows up in prices. If a local bakery is paying 8 percent on its working capital loan instead of 5 percent, that extra 3 percent gets baked into the cost of your sourdough. CPI doesn't capture that directly — it captures the final price, but not the financial friction behind it. Luna: So the fed funds rate is kind of like the thermostat setting. But the actual temperature in the room depends on how the radiator — the banking system — decides to operate. Lucas: That's a great analogy. And the Fed knows this. That's why they've been paying attention to something called the 'credit channel.' They want banks to keep lending at reasonable spreads. But they can't force them. Luna: If today was actually useful to you — understanding why your credit card rate is still climbing even though the Fed is on hold — the way these episodes stay ad-free is listener support. People who find value in walking through the economy with us can buy us a coffee at buy me a coffee dot com slash fexingo. It genuinely keeps the lights on. Lucas: Yeah, and it's a small way to say 'this is worth doing.' We really appreciate that. So back to the spread issue — the other thing that's interesting is that the IORB itself, at 3.65 percent, is actually above the fed funds rate. That's unusual. Luna: Wait — the Fed pays banks more than they can earn by lending to each other? That seems backward. Lucas: It sounds weird, but it's by design. The IORB acts as a ceiling to keep the fed funds rate from going too high. If the fed funds rate tried to rise above IORB, banks would just stop lending and park reserves at the Fed. So it caps the rate. But the unintended consequence is that it also encourages banks to hold reserves rather than lend to businesses. Luna: So the very tool meant to control inflation might be making credit tighter for the people who actually need it. Lucas: Correct. And that's why we're seeing this disconnect. The Fed has kept rates steady, but the effective cost of borrowing for households and small businesses has kept rising. The transmission mechanism is broken. Luna: What would fix it? Lowering IORB? Or something more structural? Lucas: There's debate. Some economists argue the Fed should lower IORB to encourage lending. Others say the problem is bank regulation — capital requirements that make it expensive to lend to riskier borrowers. Either way, the fed funds rate alone isn't telling the full story. Luna: So when we hear 'the Fed held rates steady,' we should be asking 'but what are banks actually doing?' Lucas: Exactly. And that's where the inflation story gets real. The 4.2 percent CPI number is backward-looking. The cost of credit is forward-looking. And right now, that forward look says prices aren't coming down anytime soon. Luna: Especially with wholesale prices jumping 1.1 percent in May. That's going to feed through to consumer goods later this year. Lucas: Right. And the 10-year breakeven inflation rate — the market's expectation for average inflation over the next decade — is at 2.29 percent, down from 2.34. That suggests the bond market thinks inflation will moderate, but not quickly. It's a slow grind. Luna: So for the average person, the advice might be: don't expect relief from your credit card or auto loan rates anytime soon, even if the Fed doesn't hike again. Lucas: That's the bottom line. The fed funds rate is a headline. The real cost of money is in the spreads. And until those spreads compress, inflation will feel stickier than the official numbers suggest.