What is the federal funds rate?

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What is the federal funds rate?

by NCA Financial … on Nov 6, 2018

Finance

The federal funds rate is the interest rate at which banks lend funds to each other from their deposits at the Federal Reserve (the Fed), usually overnight, to meet federally mandated reserve requirements. If a bank is unable to meet its reserve requirements at the end of the day, it borrows money from a bank with extra reserves. The federal funds rate is what banks charge each other for overnight loans. This rate is referred to as the federal funds effective rate and is negotiated between borrowing and lending banks.

The Federal Open Market Committee (FOMC) sets a target for the federal funds rate. The Fed does not directly control consumer savings or credit rates directly; it can't require that banks use the federal funds rate for loans. Instead, the Fed lowers the federal funds rate by buying government-backed securities (usually U.S. Treasuries) from banks, which adds to the banks' reserves. Having excess reserves, banks will lower their lending rates for overnight loans to make some interest on the excess reserves. To raise rates, the Fed sells securities to banks, decreasing the banks' reserves. If enough banks need to borrow to meet overnight reserve requirements, banks with extra reserves will raise their lending rates.

The federal funds rate serves as a benchmark for many short-term rates, such as savings accounts, money market accounts, and short-term bonds. Banks also base the prime rate on the federal funds rate. Banks often use the prime rate as the basis for interest rates on deposits, bank loans, credit cards, and mortgages.

The FOMC is the policymaking branch of the Federal Reserve. One of its primary responsibilities is setting the federal funds target rate. The FOMC meets eight times per year, after which it announces any changes to the target rate. The Federal Reserve (the Fed), through the FOMC, uses the federal funds rate as a means to influence economic growth.

If interest rates are low, the presumption is that consumers can borrow more and, consequently, spend more. For instance, lower interest rates on car loans, home mortgages, and credit cards make them more accessible to consumers. Lower interest rates often weaken the value of the dollar compared to other currencies. A weaker dollar means some foreign goods are costlier, so consumers will tend to buy American-made goods. Increased demand for goods and services often increases employment and wages. All of which should stimulate the economy. This is essentially the course the FOMC took following the 2008 financial crisis in an attempt to spur the economy.

However, if money is too plentiful, demand for goods may exceed supply, which can lead to increasing prices. As prices rise (inflation), demand for goods decreases, slowing overall economic growth. When the economy recedes, the need for labor decreases, unemployment grows, and wage growth slows. To counteract rising inflation, the Fed raises the target rate. When interest rates on loans and mortgages move higher, money becomes more costly to borrow. Since loans are harder to get and more expensive, consumers and businesses are less likely to borrow, which slows economic growth and reels in inflation.

The Fed monitors many economic reports that track inflationary trends and economic growth. The Fed's preferred measure of inflation is the Price Index for Personal Consumption Expenditures produced by the Department of Commerce. To forecast economic growth, the Fed looks at changes in gross domestic product and the unemployment rate, along with several other economic indicators, such as durable goods orders, housing sales, and business fixed investment.

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