Friday, 13 May 2022

What is the Federal Funds Rate?

What is the Federal Funds Rate?
15 Mar

Updated on Tuesday, March 15, 2022

The federal funds rate is the interest rate at which depository institutions, like banks and credit unions, lend each other their excess reserves overnight.

The Federal Open Markets Committee (FOMC) of the U.S. Federal Reserve sets the federal funds rate as part of its monetary policy. As the U.S. central bank, the Federal Reserve has a dual mandate to promote maximum employment and price stability. Generally, as unemployment declines, inflation rises, and vice versa. The Fed sets the federal funds rate in an effort to bring those metrics to the best equilibrium for the economy. The rate then affects the interest rates on credit cards, mortgages, deposit accounts and more.

How does the federal funds rate work?

Financial institutions are required by law to hold a portion of their assets on reserve against their liabilities so they have enough money to cover customer withdrawals. To ensure they meet that requirement, banks lend each other money overnight with interest. The interest on those transfers must fall within the target range set by the FOMC (in other words, the federal funds rate).

In each of its eight annual meetings, the FOMC sets that federal funds rate depending on what’s happening in the economy, particularly related to inflation and unemployment. A lower federal funds rate can increase economic activity and boost employment. A higher rate can decrease economic activity and control prices.

Federal funds rate and inflation

The Fed’s dual mandate guides its decisions to change the federal funds rate. That dual mandate includes price stability, so the Fed aims to set the long-run inflation rate at 2%. When inflation is high, the Fed can raise the federal funds rate to tighten the flow of capital. Borrowing money becomes more expensive, less money becomes available and prices tend to fall over time with less economic activity.

Federal funds rate and unemployment

The other side of the dual mandate is promoting maximum employment. During the Great Recession and the beginning of the COVID-19 crisis, economic shocks caused a lot of people to lose their jobs. In response to spikes in unemployment, the Fed slashed the federal funds rate as part of an effort to facilitate economic activity and promote the lending and borrowing that leads to job creation.

Who sets the federal funds rate?

The Federal Reserve Open Market Committee (FOMC) sets the federal funds rate. The FOMC is composed of the following 12 members:

  • The seven members of the Board of Governors of the Federal Reserve System
  • The president of the Federal Reserve Bank of New York
  • Four of the other 11 Reserve Bank presidents, who rotate to serve one-year terms

The President nominates and Congress confirms the Fed chair and two vice chairs for four-year terms. The chair of the Federal Reserve often serves as the public face of the FOMC. Jerome Powell, the Federal Reserve’s current chair, first joined the Board of Governors in 2012 and has served in his current role since 2018.

The FOMC meets eight times per year to set the federal funds rate and enact other monetary policy. In some meetings, the Fed also releases its summary of economic projections (SEP). The SEP includes FOMC forecasts for metrics like inflation, unemployment and real gross domestic product (GDP) over the next few years, as well as projections for the federal funds rate.

The next Federal Reserve meeting: March 15-16, 2022

How does the federal funds rate impact consumers?

The Fed doesn’t directly change the rates on consumer loans or other products, but the federal funds rate has downstream effects across the entire economy. The ecosystem in which banks lend money to each other and to consumers is mediated by the federal funds rate, so changes to the target rate affect consumers.

How does the federal funds rate affect loans?

The federal funds rate tends to correlate with the rates charged on consumer loans. As the federal funds rate rises, banks become less likely to lend excess money to each other, since the penalty (in terms of interest) for dipping below the reserve requirement is higher. Banks often dip into the reserve requirement to provide the capital for consumer and business loans, so the rates they charge tend to tick upward as the federal funds rate rises.

How does the federal funds rate affect mortgage rates?

Much like consumer and business loan rates, mortgage rates are affected by the federal funds rate. With a high federal funds rate, mortgage rates tend to be higher (which can, in turn, help drive down the principal cost of real estate). When the federal funds rate is low, mortgage rates tend to be lower as well.

Federal funds rate changes tend to affect the interest rates on short-term loans more than long-term loans and mortgages, which correlate more strongly with the yield on 10-year Treasury bonds.

How does the federal funds rate affect deposit account rates?

The federal funds rate correlates strongly with the rates paid on deposit account balances too. In order to attract customers, banks pay interest rates on savings accounts, money market accounts and certificates of deposit (CDs). When the federal funds rate is higher, banks want to encourage deposits, so they tend to raise interest rates.

Federal funds target rate vs. effective federal funds rate

The Federal Reserve doesn’t set the exact rate at which banks lend each other their overnight reserves. Instead, they set a target — and banks must set their interest rates for transfers between institutions within that range. That effective federal funds rate can fluctuate daily, but it always lands within the target range set by the Fed. That range is usually set in increments of 25 basis points (0.00%-0.25%, 0.25%-0.50% and so on).

  • Federal funds target rate: The FOMC sets the target for the federal funds rate eight times per year, and banks must lend excess reserves at a rate within that range.
  • Effective federal funds rate: The weighted-average interest rate on transactions of excess reserves between financial institutions for a given day or month.

The Federal Reserve Bank of New York tracks the effective federal funds rate daily.

History of the federal funds rate

The federal funds rate has long been used by the Federal Reserve to promote price stability and maximum employment. After years of high inflation in the 1970s, Chairman Paul Volcker raised the federal funds target rate to 20% in June 1981, which led to a recession and skyrocketing unemployment — but did help drag down inflation from a high of 13.5% in 1980 to 3.2% by 1983.

Alan Greenspan was the chairman of the Fed for almost two decades, starting his tenure in 1987 right before a stock market crash. Then, he lowered the federal funds rate in an effort to stimulate economic activity. In 2000, Greenspan raised the target rate, which may have helped contribute to the dot-com stock bubble bursting, and lowered it the following year.

The Fed resorted to extreme measures in 2009 and 2020 under Ben Bernanke and Jerome Powell to provide support to the U.S. economy. In 2009, the subprime mortgage crisis forced the Fed to set the target rate as low as possible (0.00%-0.25%) — and didn’t raise it until December 2015. During the onset of the COVID-19 pandemic in March 2020, the Fed again set a zero-bound federal funds target rate as part of its COVID-19 relief package. Their accommodative monetary policy helped prevent a long-term recession or depression but contributed to an inflation spike.


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