What is the Federal Funds Rate

The federal funds rate is the benchmark interest rate set by the Federal Open Market Committee (FOMC). This target sets the rate at which commercial banks lend their surplus reserves to one another on an overnight basis.

The federal funds rate represents the interest charged by banks to other financial institutions for lending surplus cash from their reserve balances on an overnight basis. Legally, banks must hold a reserve equalling a certain percentage of their deposits in an account with a Federal Reserve bank.

To guarantee adequate funds for covering depositor withdrawals and other liabilities, financial institutions must maintain interest-bearing accounts at Federal Reserve banks. Excess funds in their reserve beyond the required amount can be lent to other banks facing shortfalls.

When a bank has an end-of-day balance that exceeds the mandated amount, it can lend the surplus amount to an institution with anticipated balance shortfalls. The interest rate charged by the lending bank is the federal funds rate, also called the fed funds rate.

The federal funds rate is one of the most powerful monetary tools the Federal Reserve has at its disposal. As one of the most crucial interest rates in the U.S. economy, the federal funds rate impacts monetary and financial conditions, which in turn influence vital aspects of the broader economy, such as employment, growth, and inflation.

Although indirect, the rate also affects short-term interest rates for home and auto loans, as well as credit cards.

When the economy is overheating or facing inflation, the Federal Reserve tends to raise the federal funds rate, to increase the cost of borrowing, and cool the economy. During downturns or deflationary periods, the Fed tends to lower interest rates to lower borrowing costs and spur economic activity.

Investors pay close attention to the federal funds rate, as financial markets often react significantly to target rate changes. For instance, a minor rate decrease can trigger a market surge as company borrowing costs drop.

A rise in the rate might lead to a decrease in the stock market or stock multiples, as higher borrowing costs for companies can reduce investments and slow down economic growth. Additionally, interest rates affect the prices at which investors discount their investments - if rates go up (bond yields go up), bonds become more attractive and stocks less attractive. Conversely, a decrease in the rate can make the cash flow from stock more attractive, impacting the prices and multiples accordingly.

Over time, the federal funds rate target has fluctuated in response to prevailing economic conditions. It peaked at 20% in the early 1980s due to inflation and reached a record-low target of 0% to 0.25% during the Great Recession of 2007-2009 to stimulate growth. We are now in a period of rising rates, which we haven’t seen in over 10 years.

To make decisions about rate adjustments, the FOMC examines crucial economic indicators that signal inflation, recession, or other factors impacting sustainable economic growth.

While the FOMC can’t force banks to adhere to the exact federal funds rate, it sets the target rate as a guide. The actual interest rate charged by a lending bank is negotiated between the two parties. The effective federal funds rate is the weighted average of interest rates for all such transactions. Though the Federal Reserve System cannot mandate a specific federal funds rate, it can modify the money supply to encourage interest rates to approach the target rate. By increasing or decreasing the money supply, the system can lower or raise interest rates, respectively.

In addition to the federal funds rate, the Federal Reserve establishes a discount rate, which is the interest it charges banks for direct borrowing. This rate is typically higher than the target fed funds rate to motivate banks to borrow from each other at the lower federal funds rate.

The FOMC convenes eight times annually to establish the target federal funds rate.