Fed Funds Rate, Its Impact, and How It Works

The fed funds rate is the interest rate banks charge each other to lend Federal Reserve funds overnight, but it's also a tool the nation's central bank uses to control U.S. economic growth and a benchmark for interest rates on credit cards, mortgages, bank loans, and more.

Arguably, that makes it the most important interest rate in the world.

One of the most significant rates influenced by the fed funds rate is the prime rate, 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 too. Libor, as it's commonly called, is the rate banks charge each other for one-month, three-month, six-month, and one-year loans.

Longer-term interest rates are indirectly influenced. Investors want a higher rate for a longer-term Treasury note. The yields on Treasury notes drive long-term conventional mortgage interest rates.

On Oct. 30, 2019, the Federal Reserve's Federal Open Market Committee lowered the fed funds rate to 1.5%-1.75%. This was the FOMC's third cut in 2019, following nine hikes since December 2015. Prior to that, the rate had been 0% since December 2008. To combat the financial crisis, the FOMC had aggressively lowered it 10 times in the prior 14 months.

The FOMC changes the fed funds rate to control inflation and maintain healthy economic growth. The FOMC members watch economic indicators for signs of inflation or recession. The key indicator of inflation is the core inflation rate. The critical indicator for a recession is the durable goods report.

It can take 12 to 18 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. The Federal Reserve employs 450 staff, about half of whom are Ph.D. economists.

When the Fed raises rates, 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. (More on this below.) 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 fed funds rate. Because loans are harder to get and more expensive, businesses will be less likely to borrow. This will slow down the economy.

When this happens, adjustable-rate mortgages become more expensive. Homebuyers can only afford smaller loans, which slows the housing industry. Housing prices go down. Homeowners have less equity in their homes and feel poorer. They spend less, thereby further slowing the economy.

When the Fed lowers the rate, the opposite occurs. Banks are more likely to borrow from each other to meet their reserve requirements when rates are low. Credit card rates drop, so consumers shop more. With cheaper bank lending, businesses expand. This is called expansionary monetary policy.

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.

For this reason, stock market investors watch the monthly FOMC meetings like hawks. A 0.25 percentage point decline in the fed funds rate, intended to stimulate economic growth, sends the markets higher in jubilation. If it stimulates too much growth, inflation will creep in.

Meanwhile, a 0.25 percentage point increase in the fed funds rate, intended to curb inflation, could slow growth and prompt a decline in the markets. Stock analysts pore over every word uttered by anyone on the FOMC, trying to decode what the Fed will do.

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 a bank with extra money. That's where the fed funds rate comes in. This 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. 

When the FOMC meets, it sets a target for the fed funds rate. It can't force the banks to use this target, so it uses open market operations. 

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 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. This is what the Fed charges banks to borrow from it directly through the discount window.