The Federal Reserve uses the Federal funds rate to control the interest rate banks charge for loans and pay for deposits. Although banks would like to lend every dollar they can, the Federal Reserve mandates they keep a certain percentage of deposits on hand each night. This is known as the reserve requirement. Banks hold the reserves with deposits at their local Federal Reserve branch office or cash in their own vaults. The Fed funds rate is the rate that banks charge each other for overnight loans to meet these reserve balances. The amount lent and borrowed is known as the Fed funds.
The Federal Reserve, through its Federal Open Market Committee (FOMC), targets a specific level for the Fed funds rate. It uses open market operations to push the Fed funds rate to its target. If it wants the rate lower, the Fed purchases securities from its member banks. It deposits credit onto the banks' balance sheets, giving them more reserves than they need. That means the banks need to lower the Fed funds rate to lend out the extra funds to each other. When the Fed wants rates higher, it does the opposite. It sells its securities to banks, removing funds from their balance sheet, giving them less reserves. This allows them to raise rates.
The Fed funds rate directly influences other short-term interest rates. It immediately impacts LIBOR, which is the interest rate that banks charge each other for one-month, three-month, six-month and one-year loans, and the prime rate, which is the rate banks charge their best customers. In this way, the fed funds rate also affects interest rates paid on deposits, bank loans, credit cards, and adjustable-rate mortgages.
Longer-term interest rates are indirectly influenced. Usually, investors want a higher rate for a longer-term Treasury note. The yields on Treasury notes drive long term conventional mortgage interest rates.
How the Federal Funds Rate Works
A higher Fed funds rate means banks are less able to borrow money to keep their reserves at the mandated level. This means they will lend less money out, and the money they do lend will be at a higher rate since. That's because they themselves are borrowing money at a higher Fed funds rate to maintain their reserves. Since loans are more difficult to get and more expensive, businesses will be less likely to borrow, thus slowing the economy. When the Fed raises rates, it's called contractionary monetary policy.
When this happens, adjustable rate mortgages become more expensive, so homebuyers can only afford smaller loans, which slows the housing industry. Housing prices go down, so homeowners have less equity in their homes, and feel poorer. They spend less, further slowing the economy.
When the Fed funds rate is lowered, the opposite occurs. Since overnight lending is cheaper, banks are more likely to borrow from each other to meet their reserve requirements. They lend more and at a lower rate. With cheaper bank lending, businesses expand. This is called expansionary monetary policy.
Adjustable-rate home loans become cheaper, so the housing market improves. Homeowners feel richer, and spend more. They can also take out home equity loans more easily. They usually use these loans to buy home improvements and new cars, stimulating the economy.
Why the Federal Funds Rate Is So Important
The FOMC changes the Fed funds rate to control inflation while maintaining healthy economic growth. The FOMC members watch economic indicators to determine if the economy is speeding up (inflation) or slowing down (recession). The key indicator for inflation is the core inflation rate. The most important indicator in predicting a slowdown is the durable goods report.
It can take 12-18 months for the effect of a change in the Fed funds rate to percolate throughout the entire economy. To maintain the expertise necessary to plan that far ahead, the Federal Reserve has become the nation’s expert in forecasting the economy. The Federal Reserve employs 450 staff, about half of which are Ph.D. economists.
For this reason, stock market investors watch the monthly FOMC meetings like a hawk. A 1/4 point decline in the Fed funds rate not only stimulates economic growth, but sends the markets higher in jubilation. However, if it stimulates too much growth, inflation will creep in.
A 1/4 point increase in the Fed funds rate will curb inflation, but could also slow growth and prompt a decline in the markets. Stock analysts pore over every word uttered by anyone on the FOMC to try and get a clue as to what the Fed will do.
Fed Funds vs Discount Rate
The Fed funds rate is the most important tool of the Federal Reserve, but there are others. The Federal Reserve also has a discount rate, which it keeps above the Fed funds rate. This is what the Fed charges banks to borrow from it directly through the discount window.
To combat the financial crisis of 2008, Former Federal Reserve Chairman Ben Bernanke lowered the Fed funds rate to near zero by aggressively dropping it ten times in 14 months. To see more about this, go to Current Fed Funds Rate.
Obviously, this is the lowest the Fed funds rate can go. The highest was 20% in 1979 when Federal Reserve Chairman Paul Volcker used it as a tool to combat inflation. For more on the Fed funds rate highs and lows, see Historical Fed Funds Rate. (Updated January 13, 2012)