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.

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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. 

How does a central bank “raise” interest rates? 

When describing the central bank's monetary policy actions, it is common to hear that the central bank “raised interest rates” or “lowered interest rates.” We need to be clear about this: more precisely, through open market operations the central bank changes bank reserves in a way which affects the supply curve of loanable funds. As a result, Figure 28.7 shows that interest rates change. If they do not meet the Fed’s target, the Fed can supply more or less reserves until interest rates do.

Recall that the specific interest rate the Fed targets is the federal funds rate. The Federal Reserve has, since 1995, established its target federal funds rate in advance of any open market operations.

Of course, financial markets display a wide range of interest rates, representing borrowers with different risk premiums and loans that they must repay over different periods of time. In general, when the federal funds rate drops substantially, other interest rates drop, too, and when the federal funds rate rises, other interest rates rise. However, a fall or rise of one percentage point in the federal funds rate—which remember is for borrowing overnight—will typically have an effect of less than one percentage point on a 30-year loan to purchase a house or a three-year loan to purchase a car. Monetary policy can push the entire spectrum of interest rates higher or lower, but the forces of supply and demand in those specific markets for lending and borrowing set the specific interest rates.

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.

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