The federal funds rate, sometimes called fed funds rate, is the target interest rate at which banks provide overnight loans to each other. It is one of the main tools used by the Federal Reserve to conduct monetary policy.
By controlling the federal funds rate, the Federal Reserve is able to influence the money supply. When the target rate is low, credit gets cheaper. This incentivizes borrowing. On the other hand, when the target fed funds rate is high, credit gets more expensive.
Banks today operate under a fractional-reserve banking system. This means, when a depositor deposits money at a bank, the bank will lend out most of this money.
In order to reduce risk, banks historically had to keep a certain percentage of money in their reserves. The reserve requirements fluctuate but are usually 10%.[1] Federal Reserve: “Calculation of Reserve Balance Requirements” Accessed April 22, 2022. This percentage of money is a fractional reserve.
Banks keep their reserves in a special account at the Federal Reserve. This way, in case a particular bank ever experiences a bank run, credit crunch or runs low on reserves, the Fed can lend money to the affected bank.
Instead of lending money directly to the affected bank, other banks can lend their excess reserves to the bank the form of overnight loans.[2] Federal Reserve Bank of St. Louis: “Federal Funds Effective Rate” Accessed April 22, 2022.
For example, let’s say bank A is running low on reserves but bank B has plenty of excess reserves. Bank B can lend some of its excess reserves to Bank A in the form of an overnight loan.
This way, the Federal Reserve acts as pool of reserves that individual banks can draw from during short-term liquidity problems. Before the Federal Reserve system existed, banks would often go bankrupt during bank panics where a lot of depositors withdrew their money at the same time.
Reserve requirements have changed over time. As of March 15, 2020 the reserve requirements have been permanently reduced to 0%.[3] Federal Reserve: “Reserve Requirements” Accessed April 22, 2022. [4] Federal Reserve: “Interest on Reserve Balances (IORB) Frequently Asked Questions” Accessed April 22, 2022.
Prior to 1913, before the Federal Reserve existed, some banks took on excessive risks by only keeping 1% of deposits as reserves. This led to frequent problems, which is why until recently most central banks set the reserve requirements of banks at 10%.[5] Federal Reserve: “Reserve Requirements” Accessed April 22, 2022.
The end-of-the-day balance of each account held at the Federal Reserve is averaged over a two week period and used to determine if a bank meets its reserve requirements.
Banks that expect to have excess reserves can lend these reserves to banks that expect to be in a deficit.
The federal funds rate is not an exact interest rate but rather a range. When the Fed sets the fed funds rate, the goal is that banks borrow and lend excess reserves to each other within a target range.
This range consists of an upper and lower benchmark. For example, the fed funds rate today, as of writing this article, is 0.25% to 0.50%.[6] Federal Reserve: “Federal Reserve issues FOMC statement” Accessed April 22, 2022. This means, banks should provide overnight loans to each other within this range.
Since 2008, banks earn interest on their reserves held at the Federal Reserve.[7] Federal Reserve: “Interest on Reserve Balances (IORB) Frequently Asked Questions” Accessed April 22, 2022. This is known as Interest on Reserve Balances (IORB).
The actual rate at which banks provide overnight loans to each other is known as the effective federal funds rate.
The effective fed funds rate is the weighted average of interest rates that banks charge each other on overnight loans. This depends on negotiations between the banks themselves.
For example, the target fed funds rate might be 0.00%-0.25%. But the effective federal funds rate at which banks provide overnight loans to each other, on average, might be 0.08%.
As you can see in the graph above, the effective fed funds rate dropped after each grey bar. The grey bars in the graph indicate recessions.
You will learn more about how the Fed lowers short-term interest rates in response to recessions and financial crises, such as during the 2008 Global Financial Crisis, later in this article.
The federal funds rate allows the Fed to influence the money supply. Under the fractional reserve banking system, money is lent into existence every time a bank provides a loan.[8] Federal Reserve Bank of Atlanta: “Fractional Reserve Banking – An Economist’s Perspective (Transcript)” Accessed April 22, 2022.
Let’s say person A deposits $100 at bank A. The bank keeps $10 and lends the other $90 to person B. Person B now takes the borrowed $90 and spends it on some new clothes. The clothing company receives the $90 and deposits it at bank B.
Bank B keeps 10%, or $9, as reserve and lends out $81 to person C. Person C then spends the money were it eventually ends up in a bank and is lent out again. This is known as the multiplier effect. It’s how commercial banks lend money into existence.
The federal funds rate allows the Fed to set short-term interest rates. However, the fed funds rate also impacts all other interest rates throughout the economy.
If the Federal Reserve lowers the federal funds rate, interest rates on bank deposits, mortgages and other loans will also drop.
If the Fed wants commercial banks to lend more money into existence, it needs to make borrowing more attractive and lower interest rates. When the federal funds rate is low, it incentivizes borrowing and flushes the economy with new money.
This is why the Federal Reserve often lowers the fed funds rate during economic crises.[9] Federal Reserve Bank of St. Louis: “Federal Funds Effective Rate” Accessed April 22, 2022. When the money supply contracts, this can lead to deflation, which happened during the Great Depression.
During the 2008 Global Global Financial Crisis, Federal Reserve chair Ben Bernanke lowered the fed funds rate to zero percent to prevent another deflationary depression. This kept the economy flush with money, counteracting deflation.
However, when the fed funds rate is already at zero percent and the economy is still struggling to recover, central banks might resort to more exotic ways of conducting monetary policy.
During the Global Financial Crisis, lowering the federal funds rate to zero percent was not enough. The Federal Reserve also engaged in Quantitative Easing, a strategy where central banks purchase assets like mortgage-backed securities and government bonds.[10] Federal Reserve: “Federal Reserve announces it will initiate a program to purchase the direct obligations of housing-related government-sponsored enterprises and mortgage-backed securities … Continue reading
Similar to lowering the federal funds rate, this expands the money supply and helps counteract economic contraction and deflation.
When the federal funds rate stays low for too long, this can overheat the economy, contribute to the formation of asset bubbles and cause inflation.[11] Quinn, William and Turner, John D.: Boom and Bust. A Global History of Financial Bubbles (2020), pp. 5ff.
In this case, the Federal Reserve might increase the fed funds rate. This is known as as an interest rate hike, or simply, a rate hike.
When the Federal Reserve performs rate hikes, the cost of borrowing money increases, which leads to less new loans. As a result, less money is lent into existence, reducing inflation.
In 1980, Federal Reserve chair Paul Volcker famously raised the federal funds rate to 20% to combat double-digit inflation.[12] Federal Reserve History: “Volcker’s Announcement of Anti-Inflation Measures” Accessed April 22, 2022.
Conducting monetary policy is a delicate balancing act. In response to the Covid-19 pandemic, the Fed lowered the federal funds rate to a range of 0.00%-0.25%. On March 16, 2022, the Fed announced the long-awaited post-Covid rate hike and raised the rate by 0.25%.[13] Federal Reserve: “Federal Reserve issues FOMC statement” Accessed April 22, 2022.
Similar to the 1980s, the Untied States is facing heightened consumer price inflation. In order to fight inflation, the Fed began rate hikes, tapering its Quantitative Easing program and announced it would reduce its balance sheet.
The Federal Open Market Committee (FOMC), the policy-making body of the Federal Reserve, sets the feds funds rate. It conducts eight regularly scheduled meetings per year but can meet more frequently if needed.[14] Federal Reserve: “About the FOMC” Accessed April 22, 2022.
Changes in the federal funds rate can impact asset prices such as stocks. When investors expect the cost of borrowing to increase, they might sell stocks. On the flip side, when interest rates are low, financial markets often respond positively.
When interest rates are low and the economy is flush with money, this can bid up prices of stocks and other assets. This is known as asset price inflation. When more money chases the same number of assets, prices of assets tend to increase.
This is one explanation why stocks and bitcoin saw a huge increase in price in 2021, after the Federal Reserve lowered rates and began its Quantitative Easing program.
More recently, in anticipation of several rate hikes and a reduction of the Fed’s balance sheet, stocks sold off.
When the money supply grows at a slower rate or even contracts, asset price inflation cools off. Less money chases the same number of financial assets, which can put downward pressure on asset prices.
The FOMC’s announcements itself are often enough to move financial markets. The stock market is forward-looking. When the Fed announces policy changes, investors react by trying to front-run the actions of the Fed.
This is why markets can experience price swings leading up to and right after FOMC meetings.
Additionally to the federal funds rate, the FOMC also sets the discount rate. While the fed funds rate is the rate at which banks can borrow reserves from each other, the discount rate is the rate banks pay when borrowing directly from the Fed.
The discount rate tends to be higher than the fed funds rate to incentivize banks to borrow from each other instead of directly from the Fed.
The Federal Reserve acts like a pool of reserves. By pooling reserves, banks can help each other out and draw from each others reserves in case of a crisis, credit crunch, bank run or low liquidity.
At the same time, the Fed itself can lend money to struggling banks, providing more stability to the fractional-reserve banking system and preventing bank panics and mass bank failures that frequent occurred before 1913.