Federal Funds Rate
What is Federal Funds Rate?
The federal funds rate is the interest rate at which banks lend their excess reserves to other banks overnight.
The Federal Open Market Committee sets a target for this rate to influence borrowing costs across the economy. Changes in the federal funds rate affect consumer and business loans, investment, and overall economic growth. It is the primary tool the Fed uses to implement monetary policy.
Federal Funds Rate: a worked example
The rate setting committee announces a target of 3 percent. Banks want to hold $250 billion of reserves at that price, but the system currently holds $230 billion, so banks bid against one another for the $20 billion shortfall and the overnight rate trades up at 4 percent. The trading desk buys $20 billion of government securities, paying banks with newly created reserves. Supply reaches $250 billion, the shortage disappears, and the rate settles back to the 3 percent target. For a bank funding $30 million overnight on a 360 day year, that one point difference is worth $30 million × 0.01 ÷ 360 = $833.33 for a single night, and close to $300,000 across a year of nightly borrowing, which is why the desk's operations move real money.
The mistake students make with federal funds rate
The federal funds rate gets described as a rate the central bank sets by decree, the way it sets the discount rate. The committee announces a target, but the rate itself is the price banks charge each other for overnight reserves, and it only reaches that target when the trading desk buys or sells securities to change the quantity of reserves. Answers that stop at the announcement drop the open market operation step, which is precisely the step the question is testing.
Federal Funds Rate questions
Who borrows and lends in the federal funds market?
Commercial banks and other depository institutions trade with one another. A bank that ends the day above its reserve requirement lends the surplus overnight, and a bank that ends the day short borrows to meet its requirement rather than face a penalty. Consumers and ordinary firms do not participate, and the loans are typically unsecured and repaid the next business day.
Why does the federal funds rate affect car loans and mortgages?
The overnight rate sets the cost of the shortest and safest borrowing in the banking system, and every other rate is priced above it to compensate for longer terms and default risk. When overnight funding grows more expensive, banks raise the rates they quote on consumer and business loans to protect their margin. Expectations about future overnight rates also feed into longer term rates such as mortgages.
What happens to the economy when the federal funds rate rises?
Higher overnight funding costs push up rates on business loans, mortgages, and car loans, so firms postpone equipment purchases and households delay big ticket buying. Aggregate demand shifts left, real GDP growth slows, and inflationary pressure eases while unemployment tends to rise in the short run. A higher rate also attracts foreign financial capital, which appreciates the currency and reduces net exports.
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