Exactly How Does the Fed "Cut" The Fed Funds Rate?

A reader asks:

I was wondering why articles say that the Federal Reserve cuts the Federal fund rates. I try to bring it up in discussions in my economics class but others say that the federal reserve doesn't cut the federal funds rate. I understand that the Fed, through the FOMC, can cut the Federal funds rate. I guess my question is how exactly does the Federal Reserve "influence" the FOMC to cut the Federal funds rate. This came to my concern when I was reading this article: A Primer on Current Federal Reserve Interest Rates. Thanks for your time.

You both are correct. The FOMC sets a target for the Fed funds rate at its monthly meeting. This Federal interest rate is charged for Fed funds, which are loans made by banks to each other to meet the Fed reserve requirement. Technically, these rates are set by the banks themselves, not the Federal Reserve.

However, for the most part, these rates rarely vary from the target rate. This is because the banks know that the Fed will use its other tools, such as the reserve requirements, discount rate and reserve balance supply, to create pressure on the Fed funds rate to meet its target. This is exactly what happened most recently in the 2007 Banking Liquidity Crisis.

Related Reading

• The Federal Reserve System
• The Fed Funds Rate and How It Works
• Federal Reserve Bank of New York, "Federal Funds"