What Is Fed Funds Rate?
The Fed funds rate is the target interest rates that commercial banks charge each other for overnight lending of their excess reserves held at the Federal Reserve. It is a cornerstone of U.S. monetary policy, representing the primary tool the Federal Reserve uses to influence the availability and cost of money and credit in the economy. This rate is set by the Federal Open Market Committee (FOMC) and is crucial for guiding economic conditions, including inflation and economic growth. While the FOMC sets a target range, the actual rate at which banks lend to each other is known as the effective federal funds rate, which is a volume-weighted median of these overnight transactions.29
History and Origin
The federal funds market began in the 1920s as banks with excess reserves started lending to those with deficits to meet their reserve requirements.28 Initially, the Federal Reserve did not specifically target the federal funds rate. However, by the 1960s, the Fed actively monitored this rate to assess money market conditions. In the 1970s, the FOMC began setting explicit targets for the federal funds rate as a direct part of its monetary policy strategy.27 This shift marked the formal establishment of the Fed funds rate as the central bank's primary lever for influencing the economy. The Fed uses various tools, primarily open market operations, to influence the supply of reserves in the banking system, thereby guiding the effective federal funds rate toward its target range.26 The Federal Reserve Bank of San Francisco offers further details on the evolution of this crucial rate and its role in monetary policy.
Key Takeaways
- The Fed funds rate is the target range for overnight lending between commercial banks of their reserve balances at the Federal Reserve.
- It is set by the Federal Open Market Committee (FOMC) typically eight times a year as a key component of U.S. monetary policy.25
- Changes in the Fed funds rate influence a broad spectrum of other interest rates throughout the economy, including those for consumer loans and mortgages.24
- The rate is a primary tool for the Federal Reserve to manage unemployment, stimulate or slow economic growth, and control inflation.
Interpreting the Fed Funds Rate
The Fed funds rate serves as a benchmark that signals the Federal Reserve's stance on monetary policy. When the FOMC raises the target rate, it indicates a tightening of monetary policy, aiming to curb inflation by making borrowing more expensive and encouraging saving. Conversely, a reduction in the target rate signifies an easing of policy, intended to stimulate economic growth by lowering borrowing costs and promoting spending and investment.22, 23
Economists and investors closely monitor changes in the Fed funds rate to anticipate future economic trends and adjust their strategies. For instance, a higher rate generally implies a more expensive environment for businesses to borrow and expand, potentially slowing corporate profits and affecting financial markets.21
Hypothetical Example
Imagine two commercial banks, Bank A and Bank B, at the end of a business day. Bank A has excess reserves beyond what is required by the Federal Reserve, while Bank B finds itself with a shortfall in its required reserves. To meet its reserve requirements, Bank B needs to borrow funds overnight.
Bank A, looking to earn a return on its surplus, is willing to lend to Bank B. The interest rate they negotiate for this overnight lending is influenced by the Federal Reserve's target Fed funds rate. If the Fed's target range is, for example, 4.25% to 4.50%, Bank A might offer to lend to Bank B at 4.35%. This transaction helps Bank B cover its short-term liquidity needs and allows Bank A to earn interest on its excess funds, all within the framework set by the central bank.
Practical Applications
The Fed funds rate has pervasive impacts across the financial system and the broader economy:
- Consumer Lending: Changes in the Fed funds rate directly influence the prime rate, which is a benchmark for many variable-rate consumer loans, including credit cards, home equity lines of credit, and certain auto loans. When the Fed raises its target, these rates tend to rise, making borrowing more expensive for consumers.20
- Mortgage Rates: While not directly tied, long-term interest rates, such as those for mortgages, often move in tandem with the Fed funds rate over time. A rising Fed funds rate can lead to higher mortgage costs, affecting housing market activity.19
- Business Investment: The cost of corporate borrowing is influenced by the Fed funds rate. Lower rates can encourage businesses to take out loans for expansion, equipment, and hiring, thereby stimulating economic growth.18
- Savings Accounts: Banks often adjust the interest rates they offer on savings accounts and certificates of deposit in response to changes in the Fed funds rate. Higher rates can incentivize saving.17
- Financial markets: The Fed funds rate is a critical indicator for investors. Changes, or even anticipated changes, can lead to fluctuations in bond yields and stock prices, as borrowing costs for companies and the attractiveness of fixed-income investments shift.15, 16 Reuters provides additional insights into how the Fed funds rate affects personal finances.
Limitations and Criticisms
While the Fed funds rate is a powerful tool, its effectiveness can face limitations. One significant constraint occurs when the target rate approaches the "zero lower bound," limiting the Federal Reserve's ability to stimulate the economy further through rate cuts alone. In such scenarios, the Fed might resort to unconventional tools like quantitative easing.14
Another criticism revolves around the time lag between policy changes and their full impact on the economy. It can take several months for changes in the Fed funds rate to ripple through the financial system and affect consumer and business behavior.13 Critics also point out that while the Fed primarily influences short-term interest rates, longer-term rates are influenced by broader market forces, potentially complicating the central bank's efforts.12 The International Monetary Fund (IMF) has also raised concerns about central banks potentially keeping policy "too tight for too long," highlighting broader limitations of monetary policy, which the Fed funds rate is central to.11 Furthermore, some argue that prolonged periods of very low rates could encourage excessive risk-taking in financial markets or contribute to asset bubbles.10
Fed Funds Rate vs. Discount Rate
The Fed funds rate and the discount rate are both key interest rates set by the Federal Reserve, but they serve different purposes and apply to different types of lending.
The Fed funds rate is the target rate for overnight lending between commercial banks, where banks with excess reserves lend to banks with deficits. This lending occurs in the open market, and the Fed influences it primarily through its open market operations and by adjusting the interest it pays on reserve balances.8, 9
In contrast, the discount rate is the interest rate at which commercial banks can borrow directly from the Federal Reserve's lending facility, known as the discount window.7 While banks can borrow from each other at the Fed funds rate, they might turn to the discount window as an alternative source of short-term liquidity, especially during periods of stress. Historically, borrowing from the discount window has sometimes carried a stigma, suggesting a bank is in distress, although the Fed encourages its use to support financial stability. The discount rate is typically set at a higher level than the Fed funds rate to encourage interbank lending first.
FAQs
How does the Federal Reserve influence the Fed funds rate?
The Federal Reserve influences the Fed funds rate through various tools, primarily open market operations. This involves buying or selling U.S. Treasury bills and other securities in the open market. By buying securities, the Fed injects money into the banking system, increasing reserves and putting downward pressure on the Fed funds rate. By selling securities, it withdraws money, reducing reserves and pushing the rate up. The Fed also uses the interest it pays on banks' reserve balances to guide the rate.5, 6
What is the "effective" federal funds rate?
The effective federal funds rate (EFFR) is the actual weighted average interest rate at which commercial banks lend their excess reserves to one another overnight. While the Federal Open Market Committee (FOMC) sets a target range for the Fed funds rate, the EFFR reflects the real-time market rate based on the volume of these daily transactions.4
How does the Fed funds rate impact my personal finances?
Changes in the Fed funds rate indirectly influence many consumer interest rates, including those on credit cards, adjustable-rate mortgages, and auto loans. When the Fed raises the rate, borrowing costs generally increase for consumers, while savings account yields might also rise. Conversely, a lower rate typically leads to cheaper borrowing but lower returns on savings.2, 3
How often does the Federal Reserve change the Fed funds rate?
The Federal Open Market Committee (FOMC) typically meets eight times a year on a scheduled basis to assess economic growth and inflation and determine whether to adjust the target range for the Fed funds rate. However, the FOMC can hold unscheduled meetings and make changes more frequently if economic conditions warrant it, such as during periods of significant financial turbulence.1