Federal Interest Rates: How They’ve Changed Throughout History and What’s Affected Them

If there’s one immutable truth about the U.S. economy, it’s that it undergoes cycles that repeat themselves over time. Each cycle contains certain stages, some beneficial and some that have negative consequences. However, even the beneficial stages can have negative effects if they’re allowed to spin out of control. The federal government historically has used monetary policy to maintain financial stability and minimize the the wide swings that can occur within a particular cycle. The federal interest rate is a vital part of that policy.

What Is the Federal Interest Rate?

The federal interest rate is called the federal funds rate, and it’s the rate banks use when they loan each other money overnight, using reserves they keep at their local Federal Reserve bank. These overnight loans help banks maintain reserves required by law to preserve liquidity — in other words, it’s the banks way to ensure they can cover withdrawals from depositors’ accounts.

Although the banks themselves set the rate for these loans, the rate is influenced by the federal funds target rate, which is actually range of rates set by the Federal Reserve’s Federal Open Market Committee.

The committee meets eight times per year to review economic and financial conditions and determine a course of action to keep prices stable and employment growth sustainable. That course of action often involves increasing or decreasing the federal funds rate.

As of Oct. 28, the FOMC’s target federal funds rate range is 5.25% to 5.50%. The effective federal funds rate at which banks make the overnight loans is 5.33%.

What Is the Prime Rate?

Unlike the federal funds rate set by the FOMC, the prime rate is set by individual banks, with no direct involvement by the Federal Reserve. It’s called a reference rate, or base rate, because banks use it to set rates on some types of consumer and business loans, including credit cards and adjustable-rate mortgages. A bank’s prime rate is the best rate available for customers with prime credit.

Although individual banks set their own prime rates, you can find published prime rates that represent a broader range of banks’ prime rates. The prime rate reported by the Federal Reserve is the prime rate quoted by a majority of the nation’s 25 largest banks. The prime rate published by The Wall Street Journal is the base rate on corporate loans posted by at least 70% of the 10 largest U.S. banks. As of Oct. 28, the Federal Reserve and The Wall Street Journal both report the prime rate to be 8.50%.

You’ll note that the prime rate is about 3% higher than the federal funds rate. That’s because banks set their prime rates by adding a margin to the federal funds rate. The margin is usually about 3%.

Monetary Policy, the Federal Funds Rate and the Economy

The economy tends to run in economic, or business, cycles. Each cycle encompasses four stages:

• Expansion occurs when the gross domestic product increases — that is, when the country produces increasing amounts of goods and services. Expansion brings higher employment levels, higher spending and lower interest rates. It typically supports the maximum employment and stable prices the FOMC tries to maintain.

• The peak is the maximum degree of expansion that occurs in a cycle. It signals the end of expansion and the beginning of contraction.

• Contraction is when output declines, resulting in reduced GDP. Contractions are triggered by one or more events that put an end to the expansion. The COVID-19 pandemic was the most recent.

• The trough is the lowest point of the contraction. If it’s significant enough and lasts long enough, it can lead to recession.

• A new cycle begins with the next expansion, which signals recovery from the trough.

The Federal Reserve has a mandate to promote maximum employment, stable prices and moderate long-term interest rates. It does that by implementing monetary policy — increasing or decreasing the federal funds rate to control how much cash is in the economy.

Expansion is a good thing because it promotes high employment and stable prices, which in turn encourage modest interest rates. But too much expansion pours too much money into the economy. The result is skyrocketing prices — inflation — that discourage consumers from spending. That, in turn, prompts business to cut back, which leads to fewer jobs. The FOMC can slow down out-of-control expansion by increasing the federal funds rate, which reduces the amount of money in the economy.

During a contraction, which results from there being too little cash in the economy, the FOMC can increase the money supply by cutting the federal funds rate. Lower rates encourage people to borrow and spend, which leads to recovery — i.e., the next expansion, with high employment levels, stable prices and moderate interest rates.

Federal Funds Rate and the COVID-19 Pandemic

The Fed’s response to the COVID-19 pandemic is a perfect example of monetary policy in action.

Pandemic shutdowns led to widespread job loss disrupted financial markets across the globe. To mitigate damage to the economy and aid in its eventual recovery, the Fed took several steps, including lowering the federal funds target rate. The first reduction, on March 3, 2020, lowered the rate range half a percentage point, to 1% to 1.25%. The next decrease reduced the rate another 1%, to 0% to 0.25%. The prime rate dropped 1%, from 4.25% to 3.25%, as a result.

Through the height of the pandemic, still-employed Americans built savings, and economic stimulus provided consumers with additional cash. However, once the economy reopened and consumers returned to work, disruptions in the supply chain created an imbalance between the amount of money in the economy and consumers’ ability to spend it. That imbalance led to skyrocketing prices. Inflation reached 7.5% in January 2022 — the largest 12-month increase in 40 years.

The FOMC began a new series of rate hikes in March 2022 in an effort to slow the economy. The response was not immediate — Inflation peaked at 9.1% in June 2022 due in part to increases in energy prices– so rate hikes have continued. As of October 2023, inflation has dropped to 3.7%, which is still well above the 2% target set by the FOMC.

Here are the pandemic-related increases implemented so far:

Historic Federal Interest Rates and the Events That Triggered Them

The pandemic was the most recent event to affect the federal interest rate, but it’s not the only one. In fact, many different events have triggered rampant expansions and contractions over the years, threatening maximum employment and destabilizing prices. The Fed’s federal funds archive, which goes back as far as 1990, which is just a few years after the FOMC begin using federal fund rate target to implement monetary policy. The archive provides interesting insights into how historic events, and the Fed’s response to them, shape America’s economy.

1990-1992: The Gulf War Recession

Even before the Gulf War, Alan Greenspan, then-chair of the Federal Reserve, warned that the U.S. might be headed toward recession, according to a 1990 New York Times report. Despite relatively inconsequential oil shocks following Iraq’s invasion of Kuwait, the airline industry was hit hard by soaring jet fuel prices and a sharp decrease in trans-Atlantic flights. Other industries were also affected as consumer confidence fell and businesses reduced spending.

At the same time, a spate of savings and loan failures that began in 1980 and peaked in 1987 prompted Congress to enact a bailout legislation that cost American taxpayers as much as $124 billion, according to the Federal Reserve.

As Greenspan had predicted it might, a recession ensued, complete with rising unemployment. In addition, the country faced a major budget deficit and a credit crunch that made loans difficult to get, even for businesses. In response, the FOMC initiated a series of rate drops, decreasing the federal funds rate from 8.25% to 8% in July 1990 to 3% by September 1992. Here’s what those drops looked like:

1994-1995: Soft Landing

Once it had rebounded from the 1990-1991 recession, the U.S. economy entered a period of unprecedented growth. Unemployment had dropped, inflation was below 3% and the federal funds rate sat at 3%. However, as The Brookings Institution, a conservative think tank, explained, the Fed became concerned that rapid growth and fast-shrinking unemployment might trigger an increase in inflation. To head it off, the Fed began what would be an aggressive series of rate hikes meant to cool off the economy, followed by three rate reductions to temper the effects and keep inflation at bay — a result that came to be known as a soft landing.

It worked. U.S. economic performance remained strong through the rest of the decade, with low inflation, increasingly low unemployment and solid GDP growth that averaged more than 3% per year.

Here’s what those rate hikes and reductions looked like:

1995-1997: The Boom Continues

The period of 1995 through 1997 was relatively uneventful for the U.S. economy. The FOMC adjusted the federal funds rate a number of times, first downward to prevent a recession, then upward as the threat of recession subsided, leading the Fed to act preemptively to avoid an increase in inflation.

These are the changes made by the Fed to keep prices stable and unemployment low during the mid-90s boom:

1998: Global Currency Crisis

The period from 1995 to 1997 was relatively uneventful for the U.S. economy. However, the global currency crisis that had begun in 2017 when Thailand devalued its currency, the baht, to protect the currency against what PBS “Frontline” termed speculative attacks, spread to Malaysia and the Philippines in 2018, as the leaders of those countries also moved to defend their currencies against speculators.

In October 2007, Hong Kong’s stock index fell when it attempted to protect its currency by tripling lendering rates. Less than a week later, the Dow Jones Industrial Average sufferent its largest loss ever, prompting suspension of trading on U.S. stock markets. That was followed by the failure of one of Japan’s largest brokerage firms and one of its largest banks. South Korea, Brazil, Mexico and Russia were also affected — in Russia’s case, culminating in the near-collapse of its ruble and and the eventual collapse of its market.

In the U.S., Greenspan noted in September 1998 that the U.S. was ready to cut interest rates to keep the currency crisis from dampening economic growth. Later that month, the Fed reduced the federal funds rate by 0.25%. An additional in October helped the U.S. avoid recession from weakening markets. It lowered rates again in November to help prop up the credit markets.

Here’s a look at those rate cuts, which followed a 0.25% increase in 1997:

1999-2001: Dot-Com Bubble

Widespread adoption of personal computers and the World Wide Web created massive growth in information technology and telecommunications and spurred a wave of tech startups looking to get in on the action. The markets were quick to jump on the bandwagon, with a spate of initial public offerings from new tech companies with “.com” in their names — hence the term “dot-com.” Investors and venture capitalists, largely unconcerned about the viability of these new companies, engaged in a feeding frenzy, driving up the value of highly speculative investments.

Most of these companies traded on Nasdaq. From 1990 to 1999, the value of stocks traded on Nasdaq went from having 11% of the value of stocks trading on the New York Stock Exchange to having 80%, according to Goldman Sachs, which noted that the Nasdaq index grew 86% in 1999 alone.

At the same time the dot-com bubble was inflating, the financial world was concerned about the possibility that a Y2K bug would wreak havoc on technical infrastructure and the markets. The Fed had increased the money supply to reduce the threat of such a bug on the economy, which worked to the benefit of the the dot.com startups. Now it had to claw back that supply to keep the bubble from raising inflation. It did that by increasing the federal funds rate.

2001-2003: Dot-Com Bust and 9/11 Terror Attacks

The Fed’s rate hikes in response to the dot-com bubble burst the bubble, taking the market down with it as investors struggled to unload their quickly depreciating shares. To limit the market contraction and ultimate recession resulting from the crash, the Fed lowered interest rates to help prop up the economy.

The economy suffered yet another blow in 2001. The 9/11 terrorist attacks immediately reduced real GDP growth by 0.50%, according to an analysis by the U.S. Department of Homeland Security, and drove down GDP and unemployment forecasts for 2002.

The federal funds rate decreased many times from early 2001 to late 2003.

2004-2006: The Great Moderation

The Fed began raising rates again in 2004, as the housing market bubble drove economic growth, aiding in its recovery from the dot.com burst and 9/11. This period that came to be known as the Great Moderation. The Fed considered the increases to be “accommodative,” meaning that rates were lower than than they should be to keep inflation low over the long term, according to a 2005 New York Times report. Despite some cooling in the housing market near the end of 2005, analysts predicted strong GDP growth to continue into the first part of 2006.

To keep inflation at bay, the Fed increased the federal funds throughout 2004 to 2006.

2007-2008: Housing Market Collapse and Great Recession

The housing market began to decline after reaching a peak in 2006. At the same time prices were declining, global financial markets began to feel the strain of losses on mortgage-backed securities. By December of that year, the U.S. had entered the Great Recession.

What began as a modest decrease in economic activity picked up speed in 2008, adding to the strain on financial markets and sending GDP plummeting 4.3%, signaling the worst recession since World War II, according to the Federal Reserve Bank of St. Louis’s Federal Reserve History website. Investment bank Bear Stearns and the investment firm Lehman Brothers failed in 2008. AIG, a financial services and insurance firm, Citigroup and Bank of America all sought bailout money from the Federal Reserve.

As the economy weakened, the Fed implemented a number of actions to mitigate the damage, including a series of federal funds rate reductions.

2015-2018: Economy Recovers

The Fed had reduced the federal funds rate essentially to 0% by the end of 2008. It wasn’t until 2015 that it had enough confidence in the economy’s recovery from the Great Recession that it would increase rates from that unprecedented low. And even then, 2015 and 2016 saw just one increase each for a total 0.50%. Increases picked up pace in 2017.

Extreme volatility in Chinese markets contributed to the Fed’s hesitance to increase rates in 2016.

2019: Contraction Begins

The economy slowed again in 2019 due to trade disputes and overall weak global growth, CNN reported in October of that year. Although the Fed predicted that the economy would continue growing at a modest pace, consumer spending, manufacturing and business investment spending were contracting, prompting the Fed to implement a series of rate cuts — its final rate changes before the pandemic.

Where Will Rates Go as the U.S. Post-Pandemic Recovery Continues?

In its September 2023 meeting, the FOMC decided against an additional rate hike. However, in a statement following the meeting, Fed Chair Jerome Powell said the committee is proceeding carefully and will make decisions about future rates as more data becomes available. Experts from Goldman Sachs predict that the FOMC will forgo an increase when it meets in November, but their opinions regarding a December hike are divided, according to Reuters.

This article originally appeared on GOBankingRates.com: Federal Interest Rates: How They’ve Changed Throughout History and What’s Affected Them