What is the Federal Funds Rate

The federal funds rate is the interest rate at which depository institutions like banks lend reserve balances to other banks on an overnight basis. Reserves are excess balances held at the Federal Reserve to maintain reserve requirements. These requirements are put in place in order to prevent banks from lending out an amount of money which may result in an unsustainable amount of cash on hand.

The Federal Open Market Committee (FOMC) meets eight times a year to set the fed funds rate, and the Committee uses open market operations to influence the supply of money to meet the target rate. A calendar of upcoming and past meetings as well as press releases from those meetings can be found here.

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Federal Funds Rate

BREAKING DOWN Federal Funds Rate

The FOMC increases the fed funds rate by decreasing the money supply in the system, which pushes interest rates higher. This lowers the market equilibrium level of supply and demand for money. This is referred to as contractionary monetary policy. The fed funds rate is lifted in times of economic expansion and is used to cool inflation. On the contrary, the FOMC will increase the money supply to lower the target rate when the economy is sluggish, and inflation is benign. This is referred to as expansionist monetary policy.

Banks and other depository institutions maintain accounts at the Federal Reserve to make payments for themselves or on behalf of their customers. The end-of-the-day balances in these accounts are used to meet the reserve requirements mandated by the Federal Reserve. If a depository institution expects to have an end-of-the-day balance in excess of what it requires, it will lend the excess amount to an institution that expects to have a shortfall in its balance. The federal funds rate thus represents the interest rate charged by the lending institution.

How Does the Federal Funds Rate Work?

When the FOMC sets the fed funds rate, it cannot force banks to charge each other at that rate. Rather, the FOMC rate is known as a target rate. Through the open market operations described above, the FOMC works to direct the fed funds rate toward the target rate. The Fed can buy or sell securities from or to its member banks, adjusting those banks’ balance sheets in the process and impacting the reserves those banks hold. By adding funds to banks’ balance sheets, it can push them to lend out those funds to other banks in need; by removing funds, it can push banks to seek lenders.

Federal Funds Rate Vs. Federal Funds Effective Rate

In the situation described above in which one bank borrows funds from another on an overnight basis, the exact interest rate the lending bank charges is determined through negotiations between the two banks. The weighted average of this interest rate across all transactions of this type is known as the federal funds effective rate.   The target for the federal funds rate—which as noted earlier is set by the FOMC—has varied widely over the years in response to prevailing economic conditions. While it was as high as 20% in the early 1980s, the rate has declined steadily since then, and in 2008, to tackle the Great Recession, the Federal Reserve entered uncharted territory. 

Zero Interest Rate Policy

In response to the Great Recession, the Federal Reserve slashed the fed funds rate to a record low of zero (target of 0 to 0.25%). In the space of 12-months, the fed funds rate was reduced by 425 basis points. As the U.S. worked its way out of recession the fed funds rate remained at zero for nine years as policymakers remained cautious. It wasn't until December 2015 when Fed Chairperson Janet Yellen and the Committee shifted the target rate higher for the first time since 2006.

More Recent Activity

In January 2018, President Trump chose to replace Yellen as Fed Chairperson and nominated Jerome Powell as Chairman of the FOMC. Powell and the FOMC have continued to raise rates and have signaled further increases through 2018. Indeed, the FOMC raised the fed funds rate three times through November of 2018. This set of increases followed three rate hikes in 2017, one in 2016, and one in 2015. The FOMC has indicated plans to raise the rate to 3.5% by 2020.

Impact of the Federal Funds Rate

The fed 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 broad economy including employment, growth and inflation. The fed funds 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 lending rate is the lending rate at which banks charge their customers. In the case of longer-term interest rates, these are indirectly influenced by the fed funds rate.

Through the fed funds rate, the FOMC can control inflation, growth, and many other crucial factors of the economy. The FOMC makes its decisions about rate adjustments based on key economic indicators which show signs of inflation, recession or other issues. These include measures like the core inflation rate or the durable goods report.

That being said, although a change to the federal funds rate will have an impact on the economy, it may take a relatively long time for that impact to be felt in all areas of the economy. Indeed, it may be more than a year before the fed funds rate change reveals its impact. For this reason, the Fed has to be extraordinarily effective at forecasting the economy well into the future.

Investors keep a close watch on the federal funds rate, too. The stock market typically reacts very strongly to changes in the fed funds rate; even a small decline in the rate can prompt markets to leap higher. However, too much growth can prompt other concerns, like inflation. For this reason, many stock analysts pay particular attention to statements by members of the FOMC in order to try to get a sense of where the fed funds rate will go.

Global Policy Rates

Benchmark interest rates around the world are different for different countries and economies. The European Central Bank (ECB) sets three separate policy rates; a deposit rate, a refinancing rate, and a marginal lending rate. The Bank of England (BoE) sets a base rate and the Bank of Japan (BoJ) sets a short-term interest rate.

Besides the fed funds rate, the Federal Reserve also sets a discount rate which remains above the fed funds rate. This rate refers to the interest that the Fed charges to banks which borrow from it directly. The discount rate and other such tools are helpful in controlling the money supply.