- Set by the Federal Reserve, the federal funds rate is the interest banks charge each other to borrow money overnight.
- Changes in the federal funds rate influence the interest rates on loans, credit cards, and bank accounts.
- The federal funds rate is the key tool the Fed uses to stimulate or slow down the economy.
The major mandate of the Federal Reserve is to keep the US financial system solvent and manage its money supply (the amount of cash and readily available funds in circulation). It does this through a balancing act involving interest rates — specifically one called the federal funds rate.
What is the federal funds rate?
The federal funds rate (or fed funds rate, for short) is only used between banks; it’s not an interest rate an individual can apply for or a financial account will earn. But it’s a key benchmark.
After the Fed sets it, the federal funds rate becomes a basis for interest charged on loans and credit card purchases, and the return offered by fixed-income investments, like bonds and annuities. The level of interest rates — how cheap or expensive it is to borrow money — affects business and consumer spending. So, through the federal funds rate, the Fed tries to keep the entire economy on course.
Here’s how it works, and the ways it can affect you.
How does the federal funds rate work?
The federal funds rate, also known as the overnight rate, is the interest commercial banks charge when they lend money to one another for extremely short-term periods — literally, overnight.
The Fed mandates this activity between banks to ensure they meet their reserve requirements. That is, it requires each bank to maintain enough cash on hand, plus a reserve balance with the central bank, to cover a certain percentage of its deposits and other liabilities on every business day.
These regulations are to make sure that a bank’s account-holders always have ready access to their money. If banks are short on funds to maintain their reserve requirement, they borrow from another — at (or very close to) the fed funds rate.
There are two types of federal funds rates:
- The federal funds effective rate is the weighted average of all the interest rates banks pay when they borrow from other banks in the country.
- The federal funds target rate is the rate set by the Federal Open Market Committee (FOMC), the Fed’s monetary policy-making body, to serve as the guidepost for what banks charge one another. Made up of the Fed’s Board of Governors and five regional Federal Reserve Bank presidents, the FOMC meets at least eight times a year to decide the federal funds rate based on prevailing economic conditions.
When people refer to the Fed “slashing the interest rate” or “raising interest rates,” they usual mean the federal funds target rate.
How does the federal funds rate affect the economy?
During its eight meetings a year, the FOMC can raise, lower, or keep the fed funds rate the same. But what motivates the committee to periodically change it? How does the Fed use it as an economy-adjusting tool?
When it needs to stimulate economic growth — production, spending, expansion — the Fed lowers the fed funds rate. This move makes it cheaper for banks to borrow money and maintain their reserves. So these banks can then lend out their extra funds at lower costs, encouraging companies and individuals to borrow to expand, invest, and buy things. It increases the money supply in the system, in technical terms.
In contrast, when the Fed needs to slow down the economy — say, because prices are climbing too fast, causing rampant inflation — it raises the fed funds rate. To prevent their required reserve balance from going into the red, member banks have to pay more interest. They then raise their interest rates to clients, which tends to slow down any form of borrowing activity. When banks don’t finance as much, the money supply contracts, and economic growth goes back to more sustainable levels.
How does the federal funds rate affect you?
The federal funds rate is an interbank interest rate. But it has a ripple effect throughout people’s financial lives, the interest they pay, and the money they earn. Among its effects:
- Prime rate: How the fed funds rate moves influences the movement of a number of interest rates, one of the most significant being the prime rate. The prime rate is the rate a bank can offer its best corporate or high-net-worth individual clients.
- Consumer loans and accounts: A shift in the prime rate influences consumer interest rates as well. When the prime rate rises or drops, you can expect a corresponding adjustment on the monthly charges of your personal loans, credit cards, and adjustable-rate mortgages. If they pay fluctuating interest, your bank accounts and CDs also earn more or less.
- US Treasuries and other bonds: Changes in the fed funds rate can be paralleled in the interest rates paid by newly issued Treasury notes and bonds. These in turn serve as a benchmark for corporate bond rates.
- Stocks: A decrease in the feds fund rate can send markets soaring, while an increase can push the markets to decline.
- Employment: When interest rates go down, it encourages consumers to buy more goods and services. In turn, this propels businesses to meet the demand by expanding production, hiring more workers, and raising wages.
The bottom line
The federal funds rate is an important tool — the tool, some would say — that the Federal Reserve uses to stimulate or slow down the economy and maintain the solvency and reliability of the nation’s banks.
Financial institutions, corporations, and individuals are all affected by the federal funds rate one way or another. There’s not much you can do to alter the Fed’s moves or even anticipate them, but it’s good to understand how it can influence your daily life and finances.