Understanding the federal funds rate: What it is and how it affects your wallet

The Federal Reserve sets the federal funds target rate, also known as the fed funds rate, which is the interest rate at which commercial banks lend to each other overnight.

Below, CNBC Select explains how and why the Federal Reserve sets this rate, and how it affects the economy, as well as your own money.

Federal regulations require financial institutions to keep a minimum amount of money in reserves. Because banks don’t earn any interest on this money, they generally try to maintain the smallest amount of reserves possible. One way they get rid of excess reserves is by lending it to other banks that have less than the mandated amount.

Similar to when the bank gives you a mortgage or auto loan, a bank will charge another bank an interest rate on these loans. That interest rate is determined by the Federal Reserve when a 12-member committee meets several times a year to set a target interest rate known as the federal funds rate. The Fed will adjust the rate to make borrowing between banks more (or less) expensive to help fulfill their mission of promoting a healthy economy for the country.

The interest rate banks charge each other informs the rates they charge their customers for products. When the Fed raises the target rate, banks increase their rates too, making credit more expensive and savings accounts more lucrative. Lowered rates, on the other hand, have the opposite effect.

Currently, we can see the former playing out. After multiple interest rate hikes, interest rates on credit cards and loans have made borrowing expensive. The impact reverberated throughout the economy. Rising mortgage rates have priced out many hopeful homebuyers and rates on auto loans have made car shopping a challenge.

On the bright side, it’s an excellent time to save as you can find interest rates on high-yield savings accounts north of 4% and even 5%. For example, the Western Alliance Bank High-Yield Savings Account, CNBC Select’s choice for earning a high APY, offers 5.20% APY. And our top pick for the best high-yield savings account, the LendingClub LevelUp Savings, offers an APY of 4.75% when you make monthly deposits of at least $250 (without deposits a 3.75% Standard APY applies).

Such high rates on credit and savings won’t last forever. If the Federal Reserve is successful in bringing inflation down, it might decide to begin lowering the federal funds rate at some point — and interest rates on consumer products will follow.

By raising the federal funds rate, the Federal Reserve aims to cool down inflation. In the ideal scenario, higher borrowing costs discourage consumers from spending money. This should prompt sellers to lower prices to retain customers. As a result, overall inflation subsides and the economy slows down.

However, slowing economic activity can lead to rising unemployment and even a recession. When that happens, the Federal Reserve needs to give the economy a boost, so it may opt to lower its target rate. This way, consumers can take advantage of lower interest rates on credit products, which gives them more spending power. People begin to use more of their budget to pay for goods and services, driving economic activity. At the same time, increased demand can lead to higher prices and more inflation.

Watching the Federal Reserve manage this balancing act with the economy might make you feel powerless, but paying attention to the federal funds rate can help you make smart financial decisions. Interest rate hikes, for example, mean you should prioritize getting rid of credit card debt and saving. When rates are low, you might think about financing a large purchase. That said, what the Fed is doing (and how it affects the economy) is just one factor you should consider when making financial decisions. Don’t base your entire budget on it.

The federal funds rate is arguably one of the most important interest rates in the world. It influences inflation and the economy in the U.S. — and your money. Tracking the Fed’s decisions allows you to set expectations about what will happen to interest rates on savings and credit products and plan accordingly.

Catch up on CNBC Select’s in-depth coverage of credit cards, banking and money, and follow us on TikTok, Facebook, Instagram and Twitter to stay up to date.