How Does the Fed Funds Rate Work and What Is Its Impact?

The fed funds rate is the interest rate banks pay for overnight borrowing in the federal funds market. The Federal Reserve uses it to influence other interest rates, such as credit cards, mortgages, and bank loans. It also affects the value of the U.S. dollar and other household and business assets. That makes it the most important interest rate in the world.

The Fed sets a target range for the fed funds rate. It has a lower bound and an upper bound. Below are the most recent target ranges.

Rates Affected by the Fed Funds Rate

One of the most significant rates influenced by the fed funds rate is the prime rate. That's the prevailing rate banks charge their best customers. The prime rate affects many consumer interest rates, including rates on deposits, bank loans, credit cards, and adjustable-rate mortgages.

There's a ripple effect on the London Interbank Offered Rate (Libor), too. Libor is used worldwide by banks to determine interest rates charged on adjustable-rate mortgages. Libor will be phased out sometime after 2021.

The fed funds rate indirectly influences even longer-term interest rates. 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 Fed Uses Its Rate to Control the Economy

The Federal Open Market Committee (FOMC) manages open market operations for the Federal Reserve System. Its primary tool is the fed funds rate. The FOMC changes the benchmark rate to manage inflation, promote maximum employment, and keep interest rates moderate. These actions will maintain healthy economic growth.

The FOMC members watch the core inflation rate for signs of inflation. This measure of inflation removes volatile food and gas prices. It watches the unemployment rate to ensure maximum employment.

It can take months for a change in the rate to affect the entire economy. To plan that far ahead, the Fed has become the nation’s expert in forecasting the economy. 

All this means stock market investors watch the monthly FOMC meetings like hawks. Analysts pay close attention to the FOMC in order to try and decode what the Fed will do. They know a 0.25 percentage point decline in the fed funds rate can send the markets higher in jubilation. Meanwhile, a 0.25 percentage point increase, intended to curb inflation, can prompt a decline in the markets because of concerns about slowing growth.

How the Fed Funds Rate Maximizes Employment

When the Fed lowers the rate, it's called expansionary monetary policy. Banks offer lower interest rates on everything from credit card rates to student and car loans.

Adjustable-rate home loans become cheaper, which improves the housing market. Homeowners feel richer and spend more. They can also take out home equity loans more easily, spending that money on home improvements and new cars. These actions stimulate the economy.

In an emergency response to the COVID-19 pandemic, the FOMC lowered the target for the fed funds rate twice in March 2020, dropping it by a total of 1.5 percentage points to its current rate of virtually zero. The Dow Jones Industrial Average fell almost 13% on March 15.

The last and only other time the Fed was that aggressive was in December 2008. In a massive effort to stem the financial crisis of 2008, the FOMC lowered the fed funds rate 10 times in 16 months.

How the Fed Funds Rate Manages Inflation

When the Fed raises rates, the opposite occurs, and it's called contractionary monetary policy. A higher fed funds rate means banks are less able to borrow money to keep their reserves at the mandated level. As a result, they lend less money out. The money they do lend will be at a higher rate because they are borrowing money at a higher rate.

As loans become more expensive, consumers and businesses borrow less. This slows down the economy.

For example, adjustable-rate mortgages become more expensive. Homebuyers may only be able to afford smaller loans, which slows the housing industry. Housing prices go down and homeowners have less equity in their homes. They may spend less, too, thereby further slowing the economy.

How Fed Funds Actually Work

The Federal Reserve requires that banks keep an amount on hand each night. This reserve requirement prevents them from lending out every single dollar they get. It makes sure they have enough cash on hand to start each business day.

Banks hold those reserves either at the local Fed branch office or in their vaults. If a bank is short of cash at the end of the day, it borrows from another bank with extra money. That's where the fed funds rate comes in. It is the rate banks charge each other for overnight loans to meet these reserve balances. The amount loaned and borrowed is known as the federal funds. 

If the FOMC 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. It forces the banks to lower the fed funds rate so they can lend out the extra funds to each other. That's how the Fed lowers interest rates.

When the Fed wants rates higher, it does the opposite. It sells its securities to banks and consequently removes funds from their balance sheet. This transaction gives banks fewer reserves, which allow them to raise rates.

The Federal Reserve has many other tools in addition to the fed funds rate. It has a discount rate that it keeps above the fed funds rate. The discount rate is what the Fed charges banks to borrow from it directly through the discount window.