You’ve probably heard the term federal funds rate on the news or from a family member interested in economics, but what does it mean? The federal funds rate is the interest rate that banks charge each other for borrowing short-term money. The Federal Reserve sets the rate that affects inflation, economic growth, borrowing and savings rates. Let’s take a closer look at how the rate is determined and its economic impact.
Key learning points
- The market for federal funds evolved leading up to the Great Depression as the Fed learned to use monetary policy to achieve macroeconomic stabilization goals.
- The Federal Reserve sets a target rate to control inflation and keep banks liquid.
- While the direction of the rate can often be controversial, the Federal Reserve uses a variety of reports to decide what the rate should be.
Table of Contents
What is the Federal Funds Rate?
The federal funds rate is the interest rate that depository banks charge other banks for overnight loans of excess cash from reserve balances. For example, a bank with deposit accounts lends its extra money to another bank that needs money quickly to increase its liquidity. The lending bank draws from its excess cash reserves for a single overnight period and charges interest on that loan.
The Federal Open Market Committee (FOMC) – the committee within the Federal Reserve System that controls the federal funds rate – cannot force banks to charge the federal funds rate. Instead, the banks involved in the transaction agree on an interest rate for lending and borrowing the money. Yet the rate that banks charge each other is influenced by the effective rate of the federal funds. The reverse is also true: the interest charged between banks affects the rate of the federal funds.
The Fed can influence interest rates by controlling the country’s money supply. More money means lower interestwhile less money means higher interest rates.
Why was the Federal Funds Rate created?
The stock market crash of 1929 caused a run on banks that quickly robbed them of liquidity, resulting in a massive bankruptcy of banks across the country. In turn, their customers lost their savings. In response, the federal government created a reserve requirement that forced banks to hold a percentage of their total deposits in the form of cash. When a bank is running low on physical money, it can turn to the federal government or other institutional lender for a quick cash injection to keep its reserves up.
Reserve requirements usually depend on the number of net transaction accounts a financial institution has.
Banks are not the only financial institutions that must meet reserve requirements. Credit unions and savings and loan unions are also required to maintain a certain level of cash in their vaults or at the nearest Federal Reserve bank.
Banks borrow from each other because the interest rates of other banks are usually lower than those of the government. However, a bank can also borrow from the Federal Reserve during a period known as a discount window. Banks that borrow overnight during the discount window will receive an interest rate lower than the federal funds rate.
How does the Federal Funds rate work?
The Federal Reserve is the government agency that lends money to banks and other credit institutions. It determines the interest rate when banks borrow money from the Federal Reserve. The FOMC meets eight times a year to discuss and ultimately set the target rate of federal funds.
Open market operation (OMO) — the Fed’s policy of selling and buying securities on the open market — affects credit institutions that borrow from the Fed nationwide. The purchase or sale of bonds affects banks directly by an increase or decrease in liquidity.
Selling bonds lowers liquidity for banks, reduces the amount they have to trade and raises the federal funds rate. Unlike, the government can buy back bondslowering the federal funds rate and leaving banks with liquidity to trade.
How the Federal Funds Rate is Used to Control the Economy
You may have noticed that the media reacts strongly when the Federal Reserve raises or lowers interest rates. That’s because the rate of federal funds directly affects the economy in nearly all lending areas.
Raising the Fed Funds rate
Credit cards that tie their interest rates to the Federal Reserve Rate charge more interest on existing balances and purchases when the Fed Funds rate rises. Mortgage rates are also rising, as are car loans. The general effect of higher Fed Funds rates is that more money is taken out of the economy through debt service, leaving the average consumer with less money to spend.
On the surface, raising interest rates is viewed as something negative, as it affects individuals’ ability to pay for their living expenses. However, when too much money circulates freely in the economy, prices rise and inflationary pressures make it more difficult for people to purchase the basic necessities of everyday life.
The FOMC usually raises the federal funds rate when inflation is high because it pulls money out of the economy at all levels, resulting in a leveling out of prices and eventually a return to normal for the cost of most products.
A higher fed funds rate translates into a higher interest rate on savings products (such as your bank account, bank certificates, deposits and bonds). This encourages people to save more because they can earn a higher return.
Lowering the Fed Funds rate
Conversely, when there is not enough money circulating in the economy, the FOMC will usually lower the Federal Reserve Rate to lower the cost of borrowing at the institutional level. Banks are more likely to lend money to consumers because it is cheaper to borrow from the Federal Reserve and other lending institutions. A lower rate ensures that more money circulates in the economy at all levels.
Analysts and investors often react negatively to a rising federal funds rate, seeing it as negative for the economy. However, its importance cannot be denied. By raising the fed funds rate, the FOMC can curb rising costs, even if the lower prices take time to reach consumers.
An economic theory known as asymmetric price transmission (also known as rockets and feathers) refers to the price phenomenon of a sudden rise in price followed by a slow decline. Petrol prices are an example of this. A disruption in the supply chain can cause gas prices to rise quickly, but it can take weeks for the price to fall again. This is because lower input costs do not immediately translate into lower prices of finished products.
Similarly, the FOMC hopes that raising Fed Funds rates will cause banks to borrow less, less money will flow into the economy, and prices will fall. But that usually doesn’t happen right away.
Investors and the stock market
It’s not just the media that reacts strongly to news about the federal funds rate. The stock market is quick to respond to announcements of lower Fed Funds rates, as this means companies can borrow more cheaply and hopefully enter a period of expansion.
Similarly, the stock market tends to fall on news of higher federal funds rates, indicating inflationary pressure and the Fed trying to curb unsustainable economic growth.
The Federal Reserve is responsible for preventing another economic crash like the one in 1929. Its decisions are not always popular, but they come to their conclusion with the help of various economic reports and comments from the 12 reserve banks. The resulting consensus raises or lowers the rate of federal funds or maintains the status quo.
The impact of the Fed Funds Rate on borrowing rates
As a general rule, an increase or decrease in the federal funds rate results in a corresponding increase or decrease in the amount of interest charged by lenders. This is because the federal funds rate directly affects the federal prime rate.
The prime rate is what banks charge their most creditworthy customers – generally 3% higher than the federal funds rate. For example, a federal funds rate of 3.25% results in a prime rate of 6.25%.
Lenders use the prime rate for short- and medium-term loans and consumer lines of credit, then add additional interest to cover the cost of taking out the loan and making a profit. For another example, when the Fed Funds rate is 6.25%, a borrower taking out a $300,000 home loan with a 20% down payment can expect to pay 9.25% interest on a 30-year fixed mortgage.
The prime rate is influenced by the federal interest rate, which applies to all credit institutions in the US. But it’s not a law. It is possible to find lenders offering loans and lines of credit for less than the prime rate. Always read the terms and conditions when getting a loan from a lender with interest rates lower than the prime rate.
The federal funds rate is an integral part of the US financial system. It helps ensure that the banking sector functions efficiently and helps stabilize inflation when prices threaten to run too high. Investors need to know the current federal funds rate to make better investment decisions with their money in terms of savings and borrowing.
Tracking information from the Consumer Price Index (CPI) and the Personal Consumption Expenditure Index (PCE) ahead of FOMC meetings can help you anticipate the actions the Fed will take stimulate or slow down economic growth.
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