The federal funds rate is the short-term interest rate at which banks can borrow money from one another. A low federal funds rate implies expansionary monetary policy by a government; a low interest rate environment for businesses and consumers; and relatively high inflation. Low interest rate environments stimulate aggregate demand and employment.

In the U.S. for example, regulations set by the Federal Reserve (the Fed) call for financial institutions to maintain a certain amount of reserve funds in their Federal Reserve account each day. If a bank expects a shortfall in meeting these reserve requirements at the end of a business day, another institution that has a surplus for that day may step in and loan it funds. The interest rate that the lending bank charges for the money is the federal funds overnight rate, or the "overnight rate" for short.

Impact of the Federal Funds Rate

The federal funds rate is highly influential and often has a direct effect on the U.S. economy, because it serves as a base for interest rates offered by various financial and credit institutions to businesses and consumers. Fluctuations in the prime rate – the interest rate that banks charge their most creditworthy customers for loans, lines of credit and mortgages – follow those of the federal funds rate, generally running a few points above.

For example, a credit card company's customers with high credit ratings may receive the prime interest rate. If the federal funds rate is 2%, then the prime rate would be approximately 5%, as it runs about three points above the federal funds rate. If the federal funds rate gets lowered from 2% to 1.5%, the bank may lower the interest rate on the credit card accordingly.

What Determines the Federal Funds Rate?

The federal funds rate is determined by the supply of money, which is controlled by the Fed. The Fed seeks to establish macroeconomic stability through monetary policy, acting in accordance with the U.S. Congressional mandate to facilitate maximum employment, stable prices, and moderate long-term interest rates.

A low federal funds rate indicates expansionary monetary policy and occurs in a relatively high inflation period. To enact monetary policy, the Fed typically engages in open market operations, sets the federal discount rate or sets the reserve requirement. Open market operations, the purchase and sale of government bonds and other securities, is the most commonly used tool by the Fed. The Federal Open Market Committee, or FOMC, conducts these transactions to achieve a targeted money supply.

Under an expansionary policy, the FOMC purchases government securities, which increases the supply of money circulating in the economy and ensures a functioning banking system. Higher money supply leads to higher inflation, pushing down the federal funds rate. A low federal funds rate can also be achieved if the Fed sets a lower discount rate. If banks are able to borrow funds from the central government at a lower interest rate, the rate at which banks can borrow reserves from one another is also lower. The Fed can also change the reserve requirements of banks, which affects the amount of cash that banks must legally hold. By decreasing the reserve requirement, banks are able to loan out a larger proportion of their cash. This increases the money supply, leading to higher inflation and a lower federal funds rate.

An example of expansionary Fed policy in action is the three rounds of quantitative easing announced in November 2008, November 2010 and September 2012, respectively. According to St. Louis Federal Reserve Economic Data, the effective federal funds rate was 4.76% in October 2008, dropping to 0.16% in July 2009. This was due to the FOMC's decision to engage in a large government security purchasing program, enacting expansionary monetary policy.

In an environment with high inflation and low interest rates, it becomes relatively more expensive to save and relatively less expensive to consume. Banks that borrow funds at low interest rates can pass lower cost of debt on to consumers who have mortgages, auto loans, or credit cards. In a lower interest rate environment, businesses are more likely to undertake capital investments such as the expansion of facilities or machinery, both of which stimulate employment. The lower cost of debt to businesses also encourages expansion and keeps them from behaving too conservatively in times of weak aggregate demand.