Monetary policy tool

What Is Federal Funds Rate?

The federal funds rate is the target interest rate set by the Federal Open Market Committee (FOMC) of the U.S. Federal Reserve, representing the rate at which commercial banks lend their excess reserve balances to other depository institutions overnight on an uncollateralized basis. It is a cornerstone of U.S. monetary policy, influencing a broad spectrum of other interest rates and serving as a critical indicator within financial markets. The federal funds rate falls under the broader financial category of monetary policy, which involves actions undertaken by a central bank to influence the availability and cost of money and credit to help promote national economic goals⁴⁶.

History and Origin

The federal funds market emerged in the 1920s, enabling banks with surplus funds in their Federal Reserve accounts to lend to those with shortfalls, often for purposes like meeting reserve requirements⁴⁵. Initially, the federal funds rate reflected money market conditions, but by the 1970s, the Federal Open Market Committee (FOMC) began explicitly targeting the federal funds rate as a primary tool for conducting monetary policy⁴³, ⁴⁴. This shift marked a significant evolution in the Federal Reserve's approach to influencing the economy. The Federal Reserve has published daily federal funds rate data since July 1954, though quotes for "Federal Reserve funds" appeared in newspapers as early as 1928, recognized as an indicator of money market tightness or easiness⁴². A significant historical period saw the rate reach its highest target ever, between 19-20 percent, in December 1980, as the Fed aggressively fought high inflation⁴¹. More recently, in response to the 2008 financial crisis, the target rate was lowered to a historic low range of 0.00-0.25%, where it remained until December 2015. The Federal Reserve’s evolution in implementing its target federal funds rate has shifted over time; initially relying on open market operations to adjust the supply of reserves, the Fed now primarily uses administered rates, such as interest on reserve balances (IORB), to guide the effective federal funds rate within its target range.
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Key Takeaways

• The federal funds rate is the target interest rate for overnight lending between banks, set by the Federal Reserve's FOMC.
• It serves as a benchmark that influences a wide array of other interest rates throughout the economy.
• The Federal Reserve adjusts this rate to implement monetary policy objectives, such as promoting maximum employment and price stability (low inflation).
• Changes in the federal funds rate affect borrowing costs for consumers and businesses, influencing spending, investment, and economic growth.
• The effective federal funds rate is a weighted average of overnight federal funds transactions, typically staying within the target range set by the FOMC.

Formula and Calculation

The federal funds rate itself is not calculated by a formula in the traditional sense, as it is a target range set by the Federal Open Market Committee (FOMC). However, the effective federal funds rate (EFFR) is a calculated value. It represents the weighted average of interest rates on overnight federal funds transactions.
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The calculation for the effective federal funds rate is essentially:

Where:

• (Loan Amount_i) = The amount of each individual overnight loan of federal funds.
• (Interest Rate_i) = The interest rate charged for that specific overnight loan.
• (\sum) denotes the sum across all qualifying overnight federal funds transactions during a given business day.

This weighted average provides a real-time measure of the interest rate at which depository institutions are actually lending and borrowing reserve balances. The Federal Reserve influences this market-determined rate primarily through tools like the interest on reserve balances (IORB) rate.
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Interpreting the Federal Funds Rate

The federal funds rate is a crucial indicator of the Federal Reserve's monetary policy stance. A higher federal funds rate generally signals a tightening of monetary policy, aimed at slowing economic growth and combating inflation by making borrowing more expensive. ³⁶, ³⁷Conversely, a lower federal funds rate indicates an easing of monetary policy, designed to stimulate economic growth and reduce unemployment by making borrowing cheaper.
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The rate's interpretation extends beyond its numerical value. Economic observers closely watch the FOMC's target range for the federal funds rate, as changes or anticipated changes reflect the central bank's outlook on inflation, employment, and overall economic activity. When the Fed raises the rate, it generally expects to see a dampening effect on demand and spending, while a reduction is intended to encourage economic expansion. The effective federal funds rate provides a daily measure of how well the Fed's policy tools are guiding market interest rates toward the target range.
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Hypothetical Example

Imagine the U.S. economy is experiencing robust economic growth, but inflation is steadily rising above the Federal Reserve's comfort level. To address this, the FOMC decides to raise the target range for the federal funds rate from 2.00%–2.25% to 2.50%–2.75%.

Here's how this might play out:

1. Fed's Action: The Federal Reserve increases the interest it pays on reserve balances held by banks. This makes it more attractive for banks to hold funds at the Fed rather than lend them out at lower rates in the federal funds market.
2. ³², ³³Interbank Lending: Banks with excess reserves now demand a higher rate when lending to other banks overnight, as they have a higher "reservation rate" (the IORB) offered by the Fed. This³¹ pushes the effective federal funds rate up towards the new target range.
3. Wider Impact: As the federal funds rate rises, it influences other short-term interest rates, such as the prime rate that banks charge their most creditworthy customers. Subs³⁰equently, rates on consumer loans, credit cards, and certain business loans also tend to increase, making borrowing more expensive across the economy.
4. Economic Response: Businesses may scale back investment due to higher borrowing costs, and consumers might reduce spending on big-ticket items. This collective reduction in spending and investment helps to cool demand, which in turn can help to curb inflationary pressures.

Practical Applications

The federal funds rate is central to the functioning of the U.S. financial system and has several practical applications across various economic sectors:

• Monetary Policy Implementation: It is the primary tool the Federal Reserve uses to influence the overall supply of money and credit in the economy. By a²⁸, ²⁹djusting the federal funds rate target, the Fed aims to achieve its dual mandate of maximum employment and price stability.
• Benchmark for Other Rates: The federal funds rate serves as a key benchmark for a wide range of short-term interest rates in financial markets, including commercial paper, certificates of deposit, and interbank lending rates. It also indirectly influences longer-term rates.
• Influence on Consumer Lending: While the Federal Reserve does not directly set mortgage rates or auto loan rates, changes in the federal funds rate can indirectly affect these consumer borrowing costs. When the federal funds rate increases, it typically leads to higher rates on various forms of consumer credit, such as credit cards and adjustable-rate mortgages. Simi²⁷larly, lower rates tend to reduce borrowing costs for consumers. However, the connection is not always direct or immediate, as mortgage rates, for instance, are also influenced by factors such as the 10-year Treasury yield and market expectations of future Fed actions.
• ²⁵, ²⁶Economic Forecasting and Analysis: Economists, investors, and businesses closely monitor the federal funds rate and the FOMC's statements for insights into the central bank's outlook on the economy. These insights help in forecasting future economic conditions, investment strategies, and business planning.
• International Capital Flows: Changes in the federal funds rate can influence capital flows between the U.S. and other countries, impacting exchange rates and the attractiveness of U.S. investments relative to those abroad.

Limitations and Criticisms

Despite its central role, the federal funds rate as a monetary policy tool faces certain limitations and criticisms:

• Indirect Impact on Long-Term Rates: While the federal funds rate directly influences short-term rates, its impact on longer-term interest rates, such as those for 30-year mortgages or long-term bonds, is indirect and can be less predictable. Othe²³, ²⁴r factors, including inflation expectations, global capital flows, and the supply and demand for bonds, also play significant roles in determining long-term yields.
• ²²Lagged Effects: Monetary policy changes, including those to the federal funds rate, often have a delayed impact on the real economy. These "lags" can make it challenging for the Federal Reserve to time its interventions perfectly, potentially leading to overshooting or undershooting its objectives.
• ²¹Zero Lower Bound: During periods of severe economic downturn, the federal funds rate can hit the "zero lower bound," where it cannot be lowered further, limiting the Federal Reserve's ability to stimulate the economy through traditional interest rate reductions. This can necessitate the use of unconventional monetary policies like quantitative easing.
• ¹⁹, ²⁰Political Pressure and Independence: Central banks, including the Federal Reserve, can face political pressure regarding interest rate decisions, which some argue could compromise their independence and effectiveness. Main¹⁶, ¹⁷, ¹⁸taining central bank independence is often seen as crucial for effective monetary policy aimed at long-term price stability.
• ¹⁴, ¹⁵Effectiveness in Crises: Critics argue that interest rate policy may become less effective during economic crises or recessions, as the relationship between interest rates and borrowing by households and businesses can break down. Some¹³ economists suggest that low interest rates maintained for too long can create imbalances in the economy, potentially contributing to future crises.

¹¹, ¹²Federal Funds Rate vs. Discount Rate

While both the federal funds rate and the discount rate are interest rates set by the Federal Reserve, they refer to distinct lending mechanisms within the banking system.

Confusion between the two often arises because both are central bank-administered rates that impact the availability of funds to banks. However, the federal funds rate reflects the cost of banks borrowing reserves from each other, whereas the discount rate is the cost of borrowing directly from the central bank as a lender of last resort. Chan¹⁰ges in the federal funds rate target are the primary mechanism through which the FOMC conducts monetary policy.

FAQs

What is the Federal Reserve's goal in setting the federal funds rate?

The Federal Reserve sets the federal funds rate target to achieve its dual mandate: promoting maximum employment and maintaining price stability (low and stable inflation). Adju⁸, ⁹sting the rate influences overall economic activity to meet these goals.

How often does the Federal Reserve change the federal funds rate?

The Federal Open Market Committee (FOMC) typically meets eight times a year (approximately every six to seven weeks) to assess economic conditions and decide on the target range for the federal funds rate. They⁷ can also hold unscheduled meetings and make changes outside of the regular schedule if economic conditions warrant it.

Does the federal funds rate directly affect my mortgage rate?

No, the federal funds rate does not directly control mortgage rates. Mortgage rates are influenced by longer-term Treasury yields, inflation expectations, and other market factors. Howe⁴, ⁵, ⁶ver, there is an indirect relationship: when the Federal Reserve raises the federal funds rate, it generally puts upward pressure on other interest rates in the economy, which can lead to higher mortgage rates over time.

What happens if the federal funds rate is too high or too low?

If the federal funds rate is too high, it can stifle economic growth, lead to higher unemployment, and potentially cause a recession by making borrowing prohibitively expensive. If i³t's too low for too long, it can contribute to excessive inflation, asset bubbles, and financial instability as borrowing becomes too cheap and stimulates unsustainable demand.¹, ²