What is the Federal Funds Rate?
The federal funds rate refers to the interest rate that banks charge other banks for lending them money from their reserve balances on an overnight basis. By law, banks must maintain a reserve equal to a certain percentage of their deposits in an account at a Federal Reserve bank. Any money in their reserve that exceeds the required level is available for lending to other banks that might have a shortfall.
How the Federal Funds Rate Works
Banks and other depository institutions are required to maintain non-interest-bearing accounts at Federal Reserve banks to ensure that they will have enough money to cover depositors' withdrawals and other obligations. How much money a bank must keep in its account is known as a reserve requirement and is based on a percentage of the bank's total deposits.
[Important: Banks with excess money in their reserves can earn interest by lending it to other banks with a shortfall.]
The end-of-the-day balances in the bank's account, averaged over two-week reserve maintenance periods, are used to determine whether it meets its reserve requirements. If a bank expects to have end-of-the-day balances greater than what's required, it can lend the excess amount to an institution that anticipates a shortfall in its balances. The interest rate the lending bank can charge is referred to as the federal funds rate, or fed funds rate.
The Federal Open Market Committee (FOMC), the monetary policy-making body of the Federal Reserve System, meets eight times a year to set the federal funds rate. The FOMC makes its decisions about rate adjustments based on key economic indicators that may show signs of inflation, recession, or other issues. The indicators include measures like the core inflation rate and the durable goods report.
The FOMC cannot force banks to charge that exact rate. Rather, the FOMC sets a target rate. The actual interest rate a lending bank will charge is determined through negotiations between the two banks. The weighted average of interest rates across all transactions of this type is known as the effective federal funds rate.
While the FOMC can't mandate a particular federal funds rate, the Federal Reserve System can adjust the money supply so that interest rates will move toward the target rate. By increasing the amount of money in the system it can cause interest rates to fall; by decreasing the money supply it can make interest rates rise.
The target for the federal funds rate has varied widely over the years in response to the prevailing economic conditions. It was set as high as 20% in the early 1980s in response to inflation. With the coming of the Great Recession of 2007 to 2009, the rate was slashed to a record low target of 0% to 0.25% in an attempt to encourage growth.
- A committee of the Federal Reserve sets a target federal funds rate eight times a year, based on prevailing economic conditions.
- The federal funds rate can influence short-term rates on consumer loans and credit cards.
- Investors also pay attention to the federal funds rate because a rise or fall in rates can sway the stock market.
The Importance of the Federal Funds Rate
The federal funds rate is one of the most important interest rates in the U.S. economy since it affects monetary and financial conditions, which in turn have a bearing on critical aspects of the broader economy including employment, growth, and inflation. The rate also influences short-term interest rates, albeit indirectly, for everything from home and auto loans to credit cards, as lenders often set their rates based on the prime lending rate. The prime rate is the rate banks charge their most creditworthy borrowers and is influenced by the federal funds rate, as well.
Investors keep a close watch on the federal funds rate, too. The stock market typically reacts very strongly to changes in the target rate; for example, even a small decline in the rate can prompt the market to leap higher. Many stock analysts pay particular attention to statements by members of the FOMC to try to get a sense of where the target rate might be headed.
Besides the federal funds rate, the Federal Reserve also sets a discount rate, which is higher than the target fed funds rate. The discount rate refers to the interest rate the Fed charges banks that borrow from it directly.