Federal funds rate target

What Is the Federal Funds Rate Target?

The federal funds rate target is a key short-term interest rate range established by the Federal Open Market Committee (FOMC) of the U.S. central bank, the Federal Reserve. It falls under the broader financial category of monetary policy, serving as a primary tool for influencing economic conditions. This target rate represents the aspirational level at which commercial banks lend their excess reserves to other depository institutions overnight on an uncollateralized basis⁴⁹. While the FOMC sets this target, the actual rate at which these transactions occur is known as the effective federal funds rate, which the Federal Reserve strives to keep within the established target range through various policy tools⁴⁸. The federal funds rate target plays a crucial role in the nation's financial system, influencing a wide range of other interest rates and impacting economic growth, employment, and inflation⁴⁶, ⁴⁷.

History and Origin

The concept of influencing short-term interest rates to manage the economy has evolved with the Federal Reserve System. For decades, the Federal Reserve has used its influence over the federal funds market as a primary mechanism to implement monetary policy. The formalization of the federal funds rate target as a central policy tool gained prominence over time as the Federal Reserve refined its approach to managing the money supply and credit conditions. Prior to 1994, the Fed often communicated its policy stance through various other means, but since then, announcing a specific target for the federal funds rate has become the standard practice, providing clear guidance to financial markets.

The Federal Reserve sets the federal funds rate target to achieve its dual mandate of maximizing employment and maintaining stable prices, typically aiming for 2% inflation⁴⁴, ⁴⁵. Historically, the federal funds rate target has seen significant fluctuations in response to prevailing economic conditions, such as combating high inflation in the 1980s or responding to economic crises like the 2008 financial crisis and the COVID-19 pandemic⁴², ⁴³. The FOMC meets eight times a year on a regular schedule to assess economic data and determine the appropriate federal funds rate target, with additional meetings possible if economic circumstances warrant³⁹, ⁴⁰, ⁴¹.

Key Takeaways

• The federal funds rate target is the interest rate range set by the Federal Open Market Committee (FOMC) for overnight lending between banks.
• It is a primary tool of U.S. monetary policy, influencing overall economic activity, inflation, and employment.³⁷, ³⁸
• Changes in the federal funds rate target affect other interest rates throughout the economy, including mortgage rates and credit cards.³⁶
• The Federal Reserve uses tools like interest on reserve balances and overnight reverse repurchase agreements to keep the effective federal funds rate within the target range.³⁵

Formula and Calculation

The federal funds rate target is not determined by a mathematical formula in the traditional sense, but rather it is a policy decision set by the Federal Open Market Committee (FOMC)³⁴. There isn't a direct algebraic calculation for the target itself, as it is a qualitative judgment based on extensive economic analysis. However, the effective federal funds rate (EFFR), which is the actual market-determined rate, is calculated as a volume-weighted median of overnight federal funds transactions³², ³³.

While there's no formula for the target, the FOMC assesses numerous economic indicators to arrive at its decision, including trends in prices, wages, employment, consumer spending, and business investments³¹. The goal is to set a target that supports the Federal Reserve's dual mandate of maximum employment and price stability.

Interpreting the Federal Funds Rate Target

Interpreting the federal funds rate target involves understanding its implications for the broader economy. When the Federal Reserve raises the federal funds rate target, it signals a desire to tighten monetary policy, typically to curb inflation or cool an overheating economy²⁹, ³⁰. This makes borrowing more expensive for commercial banks, which then passes on these higher costs to consumers and businesses through increased interest rates on loans such as mortgage rates, auto loans, and credit cards²⁷, ²⁸. The intention is to slow down economic activity, discourage excessive spending, and bring inflation under control.

Conversely, when the FOMC lowers the federal funds rate target, it indicates a move towards accommodative monetary policy, designed to stimulate economic growth and boost employment²⁵, ²⁶. This makes borrowing cheaper, encouraging spending and investment, which can help to counteract a recession or periods of low economic activity. Market participants, including investors, businesses, and consumers, closely monitor these target rate changes as they provide insight into the Federal Reserve's outlook on the economy and its future policy intentions.

Hypothetical Example

Imagine the Federal Reserve is observing a period of unusually high inflation, with prices rising rapidly across various sectors of the economy. To address this, the Federal Open Market Committee decides to raise the federal funds rate target.

Let's say the target range was previously 2.00% to 2.25%. The FOMC, after reviewing economic data, announces a new target range of 2.75% to 3.00%.

Here's how this might play out:

1. Bank-to-Bank Lending: Commercial banks, now facing a higher target, will adjust the interest rates they charge each other for overnight loans of reserves. The effective federal funds rate will likely move into this new, higher target range.
2. Broader Impact: This increase quickly ripples through the financial system. The prime rate, which banks use as a benchmark for many consumer and business loans, will also increase.
3. Consumer and Business Response:
   • A small business looking to take out a business loan for expansion might find the interest rate offered is now higher, potentially making them reconsider or delay their plans.
   • A consumer considering a new car loan might also face a higher annual percentage rate (APR), increasing their monthly payments.
   • Conversely, savings accounts and money market accounts may start offering slightly higher interest rates, incentivizing people to save more.

This hypothetical scenario illustrates how a change in the federal funds rate target aims to influence overall borrowing and spending behaviors to achieve the Federal Reserve's economic objectives.

Practical Applications

The federal funds rate target is a cornerstone of financial markets and has wide-ranging practical applications across various economic sectors.

• Monetary Policy Implementation: It is the primary tool the Federal Reserve uses to implement its monetary policy, influencing the overall availability and cost of money and credit in the economy²³, ²⁴. By adjusting the target, the Fed aims to manage inflation and support maximum employment, two key components of its dual mandate²¹, ²².
• Benchmarking Other Interest Rates: The federal funds rate serves as a benchmark for many other short-term interest rates, including the prime rate, which influences rates on consumer loans such as credit cards, adjustable-rate mortgages, and certain business loans²⁰. Changes in the federal funds rate target generally lead to corresponding adjustments in these rates.
• Impact on Financial Markets: Changes in the target rate can significantly impact financial markets. For instance, when the Fed raises the target, it can sometimes lead to declines in stock prices as higher borrowing costs can reduce corporate profits and make bond investments more attractive relative to equities. It also influences the yield curve and the value of the U.S. dollar in foreign exchange markets.
• Investment and Savings Decisions: The rate affects returns on savings accounts and money market funds. When the federal funds rate target rises, interest rates on savings accounts typically follow suit, offering savers a better return on their deposits¹⁹. Conversely, lower rates can disincentivize saving and encourage spending.
• Government Borrowing: The cost of government borrowing is also influenced by the federal funds rate, impacting treasury yields and the national debt.

The Federal Reserve's adherence to its mandate is detailed in its official publications, including its "Economy at a Glance - Policy Rate" information, which explains how changes in the target range influence the economy¹⁸.

Limitations and Criticisms

While the federal funds rate target is a powerful monetary policy tool, it is not without limitations and criticisms. One challenge is the indirect nature of its influence. The Federal Reserve directly controls certain administered rates (like the interest on reserve balances) to guide the effective federal funds rate, which then indirectly influences other market rates¹⁶, ¹⁷. The transmission mechanism can sometimes be complex and not always perfectly predictable.

Another limitation is the zero lower bound. During severe economic downturns, the federal funds rate target can be lowered to near zero, limiting the Federal Reserve's ability to further stimulate the economy through conventional interest rate cuts. This often necessitates the use of unconventional tools like quantitative easing. Critics also point to the potential for policy lags, meaning that the full effects of a change in the federal funds rate target may not be felt in the economy for several months or even longer, making it challenging for policymakers to time their interventions precisely.

Furthermore, some economists argue that focusing primarily on the federal funds rate target might lead to an overemphasis on short-term rates, potentially overlooking broader financial stability risks or contributing to asset bubbles¹⁵. The Federal Reserve's framework is subject to ongoing review and discussion, with experts offering advice on how the central bank can improve its monetary policy strategy, tools, and communication in light of past experiences¹³, ¹⁴. For example, the Brookings Institution has hosted discussions on lessons learned from recent economic challenges, including the Federal Reserve's response to inflation¹².

Federal Funds Rate Target vs. Discount Rate

The federal funds rate target and the discount rate are both interest rates set by the Federal Reserve, but they differ significantly in their purpose and how they operate. This distinction is crucial for understanding the nuances of monetary policy.

While the federal funds rate target guides the interbank lending market, the discount rate serves as an emergency lending facility. Banks typically prefer to borrow from each other in the federal funds market to meet their reserve requirements, turning to the discount window only when other options are exhausted⁸. The relative positioning of these two rates is a deliberate part of the Federal Reserve's strategy to manage liquidity and the banking system.

FAQs

How often does the FOMC meet to set the federal funds rate target?

The Federal Open Market Committee (FOMC) has eight regularly scheduled meetings each year, occurring approximately every six to seven weeks, to discuss economic conditions and set the federal funds rate target.⁵, ⁶, ⁷ They can also hold unscheduled meetings if economic circumstances require immediate action.

How does the federal funds rate target affect my savings account?

Changes to the federal funds rate target typically influence the interest rates offered on savings accounts. When the target rate rises, banks tend to offer higher interest rates on deposits to attract funds, and vice versa when the target rate falls.⁴

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 balances to each other overnight. It is a market-determined rate that the Federal Reserve tries to keep within its announced federal funds rate target range through its policy tools.², ³

Does the federal funds rate target directly control all interest rates?

No, the federal funds rate target does not directly control all interest rates. It serves as a benchmark and significantly influences short-term market rates, like those on credit cards and adjustable-rate mortgages. However, longer-term rates, such as those on 30-year fixed-rate mortgages, are also influenced by factors like inflation expectations and the supply and demand for long-term bonds.¹

What are reserve balances?

Reserve balances are the funds that depository institutions (banks) hold in their accounts at the Federal Reserve Banks. Banks are required to maintain a certain percentage of their deposits as reserves, known as reserve requirements, though these requirements have been set to zero in recent years. Banks with excess reserves can lend them to banks that need to meet their requirements, and these overnight loans occur in the federal funds market.