From Kimberly Amadeo,
Your Guide to US Economy.
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Although banks would like to loan out every dollar they can, the Federal Reserve mandates that they keep a certain amount of cash, or reserve balance, on deposit at their local Federal Reserve branch office at all times. The federal funds rate is the rate that banks charge each other for overnight loans of reserve balances.

Each month the Fed, through its Federal Open Market Committee (FOMC), targets a specific level for the federal funds rate. This rate directly influences other short-term interest rates, such as deposits, bank loans, credit card interest rates, and adjustable-rate mortgages.

Longer-term interest rates are indirectly influenced. Usually, investors want a higher rate for a longer-term Treasury note or bond.

How the Federal Funds Rate Works

A higher Fed Funds rate means banks are less willing to borrow money to keep their reserves at the mandated level. This means they will lend less money out, and that the money they do lend will be at a higher rate since they themselves are borrowing money at a higher rate. Since loans are more difficult to get and more expensive, businesses will be less likely to borrow, thus slowing the economy.

In addition, adjustable rate mortgages will become more expensive, so home-buyers can only afford smaller loans, which slows the housing industry. Housing prices go down, so homeowners have less net equity in their homes, and feel poorer.

When the Fed Funds rate is decreased, the opposite occurs. Banks lend more, businesses expand, home loans are cheaper, the housing market improves, and homeowners take out home equity loans. They usually use these loans to buy home improvements and new cars, stimulating the overall economy.

Why the Federal Funds Rate Is so Important

The FOMC changes the federal funds rate to control inflation while maintaining healthy economic growth. As difficult as this sounds, it is even harder when you realize it can take 12-18 months for the effect of the change to percolate throughout the entire economy. To maintain the expertise necessary to plan that far ahead, the Fed has become the nation’s expert in forecasting the economy.

For this reason, the stock market watches the monthly FOMC meetings like a hawk. A 1/4 point decline in the 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 increase in the 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.