Federal Funds Rate

By James Chen
Reviewed By Gordon Scott
Updated Mar 16, 2020

What Is the Federal Funds Rate?

The federal funds rate refers to the interest rate that banks charge other banks for lending to them
excess cash from their reserve balances on an overnight basis. By law, banks must maintain a
reserve equal to a certain percentage of their deposits in an account at a Federal Reserve bank.
Any money in their reserve that exceeds the required level is available for lending to other banks
that might have a shortfall.1

Key Takeaways

 The federal funds rate is the interest rate target at which banks borrow and lend excess
reserves from one another on an overnight basis.
 A committee of the Federal Reserve sets a target federal funds rate eight times a year,
based on prevailing economic conditions.
 The federal funds rate can influence short-term rates on consumer loans and credit cards.
 Investors also pay attention to the federal funds rate because a rise or fall in rates can
sway the stock market.

Understanding the Federal Funds Rate

Banks and other depository institutions are required to maintain non-interest-bearing accounts at
Federal Reserve banks to ensure that they will have enough money to cover depositors'
withdrawals and other obligations. How much money a bank must keep in its account is known
as a reserve requirement and is based on a percentage of the bank's total deposits.2

The Federal Reserve lowered the fed funds rate to a range of 0.00%-0.25% on March 15, 20203,
and Fed Chairman Jerome Powell, said in a press conference that, "We do not see negative
policy rates as likely to be an appropriate policy response here in the United States,"4

The end-of-the-day balances in the bank's account, averaged over two-week reserve maintenance
periods, are used to determine whether it meets its reserve requirements.2 If a bank expects to
have end-of-the-day balances greater than what's required, it can lend the excess amount to an
institution that anticipates a shortfall in its balances. The interest rate the lending bank can charge
is referred to as the federal funds rate, or fed funds rate.5

The Federal Open Market Committee (FOMC), the monetary policy-making body of the Federal
Reserve System, meets eight times a year to set the federal funds rate. The FOMC makes its
decisions about rate adjustments based on key economic indicators that may show signs of
inflation, recession, or other issues.5 The indicators can include measures like the core inflation
rate and the durable goods report.

The FOMC cannot force banks to charge that exact rate. Rather, the FOMC sets a target rate. The
actual interest rate a lending bank will charge is determined through negotiations between the
two banks. The weighted average of interest rates across all transactions of this type is known as
the effective federal funds rate.5

While the FOMC can't mandate a particular federal funds rate, the Federal Reserve System can
adjust the money supply so that interest rates will move toward the target rate. By increasing the
amount of money in the system it can cause interest rates to fall; by decreasing the money supply
it can make interest rates rise.

The target for the federal funds rate has varied widely over the years in response to the prevailing
economic conditions. It was set as high as 20% in the early 1980s in response to inflation. With
the coming of the Great Recession of 2007 to 2009, the rate was slashed to a record low target of
0% to 0.25% in an attempt to encourage growth.5 6

The Importance of the Federal Funds Rate

The federal funds rate is one of the most important interest rates in the U.S. economy since it
affects monetary and financial conditions, which in turn have a bearing on critical aspects of the
broader economy including employment, growth, and inflation. The rate also influences short-
term interest rates, albeit indirectly, for everything from home and auto loans to credit cards, as
lenders often set their rates based on the prime lending rate. The prime rate is the rate banks
charge their most creditworthy borrowers and is influenced by the federal funds rate, as well.

Investors keep a close watch on the federal funds rate, too. The stock market typically reacts very
strongly to changes in the target rate; for example, even a small decline in the rate can prompt
the market to leap higher. Many stock analysts pay particular attention to statements by members
of the FOMC to try to get a sense of where the target rate might be headed.

Besides the federal funds rate, the Federal Reserve also sets a discount rate, which is higher than
the target fed funds rate. The discount rate refers to the interest rate the Fed charges banks that
borrow from it directly.7