When you put $1,000 in your bank account, it doesn't sit in a vault with your name on it. The bank uses it as a money making asset. It pays you interest at one rate, then lends it out to someone else — for a mortgage, a business loan — or invests it in securities like government bonds, all at higher rates. The difference is the bank's profit.
But it's not as simple as "borrow at 2%, lend at 6%." The real math looks more like this:
Profit ≈ Interest – (Borrowed cost + Defaults + Overhead)
Real Profit = Profit - Inflation
Inflation erodes the real value of that profit.
Interest: the money banks earn from loans they make to customers.
Borrowed cost: the interest banks pay on deposits, bonds, and other funding sources.
Defaults: some loans are never repaid.
Overhead: salaries, branches, compliance, technology — all rising, often pushed higher by inflation.
Inflation: the dollars you get back in the future buy less than the ones you lent out today.
A loan where the borrowed cost is 2% and the loan rate is 6% may look safe — a healthy 4% nominal margin. But if inflation jumps to 4%, the bank is suddenly making zero real profit.
For banks, inflation is the biggest external factor they don't control.
The Problem of Short-Term Liquidity
Banks typically borrow shorter-term than they lend. While they do offer CDs and other longer-term deposits, most of their funding comes from checking and savings accounts that can be withdrawn on demand. Meanwhile, the banks' biggest assets are mortgages, business loans, and securities that stretch years or decades. Cash sitting around is not only not earning interest but is losing value due to inflation, so banks try to minimize it. This means banks are constantly managing short-term liquidity to cover withdrawals and payments. Some money comes in by new deposits and loan repayments.
Banks turn to short-term funding markets:
Borrowing from other banks overnight in the federal funds market.
Borrowing directly from the Federal Reserve at the discount window (collateralized).
Using the repo market, selling securities and agreeing to buy them back.
This constant need for short-term borrowing is an important part of the plumbing of the financial system. But it makes banks completely dependent on the overnight interest rate.
The Fed Funds Rate: The Floor of the Economy
The Fed sets a target range for the federal funds rate and steers the market rate within it. This is the interest rate banks pay each other for overnight loans. That rate acts as an effective floor for short-term money-market rates, anchoring the broader structure of interest rates.
No bank will lend to you at 3% if it can earn 4% overnight with no risk.
Raise the floor, and mortgages, car loans, credit cards, and business credit all climb.
Lower it, and borrowing costs fall across the board.
The Fed doesn't just regulate banks — it anchors the price of overnight money.
Inflation and the Cost of Credit
The Fed only directly controls short-term rates. Long-term rates are set by the market — but the market relies on Fed credibility.
When investors buy a 30-year mortgage or corporate bond, they're betting on what inflation will look like for decades. If they trust the Fed to keep inflation near 2% and the economy strong without overheating, they'll accept lower long-term rates. But if they doubt the Fed's commitment or ability, they demand higher rates to protect themselves.
This is why the Fed's 2% inflation target matters so much. It's not just a number — it's a promise that helps markets price long-term loans. Without that credibility, banks can't offer reasonable rates on mortgages or business loans, and credit becomes expensive for everyone.
Banks may also restrict credit if they think the economy will do poorly and debtors will not be able to pay.
General Effects of Interest Rates and Unemployment
If interest rates are lowered, it's easier for businesses to get money to invest and grow and in general the economy should improve. In addition individuals can get home and auto loans which helps the economy.
If unemployment gets too low, wages will start to rise and that can create inflation.
The Fed's Dual Mandate
The Fed's job isn't just inflation. It has a dual mandate: stable prices and maximum employment.
Stable inflation means banks can lend confidently (2% target).
Strong employment maximizes economic output and reduces hardship. Zero percent unemployment is not desired because it causes inflation. Currently the best number is thought to be somewhere around 3.5-4.5%, but the Fed deliberately doesn't commit to a specific number the way they do with inflation.
But these goals often clash. Raise rates to fight inflation, and you risk layoffs and defaults. Cut rates to fight unemployment, and you risk runaway inflation. The Fed's real challenge is pulling its lever to one side or the other — the fed funds rate — just far enough, without breaking either side.
Banks may also tighten credit if they think the economy will do poorly and debtors will not be able to pay.
Why It Matters to You
This isn't abstract. It's your mortgage, your car loan, your business credit line.
A "good Fed" that keeps inflation anchored and jobs strong gives banks confidence to lend cheaply. A shaky Fed that lets inflation run wild forces banks to protect themselves — and you pay for it with higher rates and possibly tighter credit.