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

Banks must sometimes borrow reserves from other banks on a short-term basis to meet reserve requirements. The interest on these borrowings, the federal funds rate, is highly influential because it indirectly impacts interest rates for businesses and consumers throughout the economy. The rate is determined by the supply of money, which is controlled by the Federal Reserve (the Fed). The Fed seeks to establish macroeconomic stability through monetary policy, acting in accordance with the 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 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 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 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.

  1. What are some different kinds of expansionary policy?

    Learn the most popular types of expansionary policy used by the federal government and the Federal Reserve to increase the ... Read Answer >>
  2. What are some examples of expansionary monetary policy?

    Learn about expansionary monetary policy and how central banks use discount rates, reserve ratios and purchases of securities ... Read Answer >>
  3. What are the implications of a high Federal Funds Rate?

    Learn the implications of a high federal funds rate, which include constriction of the money supply, a stronger dollar and ... Read Answer >>
  4. When was the last time the Federal Reserve hiked interest rates?

    Learn about when the U.S. Federal Reserve last increased the federal funds target rate, which was in June 2006 after the ... Read Answer >>
  5. How are interest rates related to open market operations?

    Learn about open market operations and how this monetary policy tool impacts interest rates. Find out how the Fed combats ... Read Answer >>
  6. How does the Federal Reserve's set discount rate affect my personal finances?

    Discover how the Federal Reserve implements its chosen monetary policy through its discount rates, and how these actions ... Read Answer >>
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