Federal Funds Rate

Published Jan 12, 2023

Definition of Federal Funds Rate

The federal funds rate is the interest rate at which depository institutions (banks and credit unions) lend reserve balances to other depository institutions overnight on an uncollateralized basis. It is set by the Federal Reserve, or more specifically, the Federal Open Market Committee (FOMC). It is arguably one of the most important interest rates in the U.S. economy, as it influences other interest rates and economic activity.

Example

To illustrate how the fed funds rate works, let’s look at an example. Assume Bank A has excess reserves and Bank B has a shortage of reserves. Bank A can lend its excess reserves to Bank B at the fed funds rate. This rate is determined by the FOMC and is usually adjusted to meet the Federal Reserve’s economic goals.

Now, if the Federal Reserve wants to stimulate the economy, it can lower the fed funds rate. This encourages banks to lend more money to each other, which increases the money supply in the economy. This, in turn, leads to lower interest rates for consumers and businesses, which encourages them to borrow more money and spend more on consumption.

Why Federal Funds Rate Matters

The federal funds rate is one of the most important monetary policy tools the Federal Reserve has available to influence the economy, along with reserve requirements, open market operations, and the discount rate (which is similar to the fed funds rate).

By adjusting the fed funds rate, the Federal Reserve can influence the money supply in the economy and, thus, the level of economic activity. If it lowers the funds rate, it can boost economic activity, and vice versa. That means this rate is closely watched by investors, businesses, and consumers alike. It is also an important indicator of the health of the economy and can be used to predict future economic trends.