Federal Funds Rate - Explained
What is the Federal Funds Rate?
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Table of ContentsWhat is the Federal Funds Rate?How Does the Federal Funds Rate Work?KEY TAKEWAYS The Importance of the Federal Funds Rate
What is the Federal Funds Rate?
The federal funds rate is the interest rate that banks charge each other for overnight loans to meet reserve requirements. Depository institutions can also lend money to banks so that they can meet their reserve balances, the interest rate charged on such loans is called the federal funds rate. Banks in the United States have a reserve requirement they must meet, this reserve is a certain percentage of the money in their deposits with the Federal Reserve Bank. Banks that have more than the required reserve rate can lend to other banks and the federal funds rate is charged on the loan.
How Does the Federal Funds Rate Work?
In the United States, banks and depository institutions are required to have a reserve balance with which they can cater for all obligations including depositors' withdrawals. The amount of money every bank is expected to have in its reserve balance is the reserve requirement. While some banks have more that the reserve requirement, some banks have lower amounts which means they need to take loans to meet the reserve requirements. Banks with excess money in reserve can lend other banks, this is usually an overnight loan. The federal funds rate is the interest rate that banks charge other banks for overnight loans. Overnight loans are not backed by any collateral but have a guaranteed interest rate. The Federal Reserve Open Market Committee (FOMC) is the regulatory body that sets the federal funds rate. FOMC holds a meeting eight times a year to set the fed funds rate. Based on certain economic factors such as inflation FOMC adjusts the fed funds rate periodically. Despite the fed funds rate set by the FOMC, two banks can still have a mutual agreement on what interest rates will be charged in the overnight loan. This is because the fed funds rate is not mandatory, neither can it be imposed on banks. To avoid clash between depository institutions and banks, a target rate is set by the FOMC.
Here are some important points to know about federal funds rate:
- The federal funds rate is the interest rate banks and depository institutions charge each other for lending money to meet reserve requirements.
- The federal funds rate is set by the Federal Reserve Open Market Committee (FOMC).
- Economic factors such as inflation, recession and other factors are considered when setting the fed funds rate.
- The fed funds rate is not mandatory, oftentimes, banks reach a negotiation on interest rates that will be charged on overnight loans.
- An increase or a decrease in the federal funds rate can influence the stock market.
The Importance of the Federal Funds Rate
In the United States, the federal funds rate is an important monetary policy that affects the economy. It tells on the economic outplay of a country for a particular period, this is why the FOMC in the US meet eight times a year to set the federal funds rate. Economic issues and factors such as growth, employment, inflation and recession and affected by the fed funds rate. Active investors in the stock market also monitor the fed funds rate before making investment decisions. This is because changes in the funds rate influences the stock market significantly. Also, stock analysts closely monitor fed funds rate to get a direction of the stock market.