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. These funds maintain the federal reserve requirement. The nation's central bank requires that they keep this amount on hand each night. The 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.

The Federal Reserve uses the fed funds rate as a tool to control U.S. economic growth. That makes it the most important interest rate in the world.

Banks use the fed funds rate to base all other short-term interest rates. It includes the London Interbank Offering Rate, commonly called Libor. It's the rate banks charge each other for one-month, three-month, six-month, and one-year loans.

Banks also base the prime rate on the fed funds rate. Banks charge their best customers the prime rate. That's how the fed funds rate also affects most other interest rates. These include interest rates on deposits, bank loans, credit cards and adjustable-rate mortgages.

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.

The current fed funds rate is 2.25 percent. The Federal Open Market Committee raised it three times in 2018, three times in 2017, once in 2016, and once in December 2015. It expects to raise it to 3.5 percent by 2020.

Before 2015, the rate had been zero percent since December 16, 2008. The FOMC had lowered it to combat the financial crisis of 2008. The Fed had aggressively lowered it 10 times in the prior 14 months. The highest was 20 percent in 1979, when Fed Chair Paul Volcker used it to combat stagflation. The fed funds rate highs and lows are found in the historical fed funds rate. 

Banks hold the reserve requirement 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. The fed funds rate is what banks charge each other for overnight loans to meet these reserve balances. The amount loaned and borrowed is known as the federal funds. 

Each FOMC meeting sets a target for the fed funds rate. It can't force the banks to use its targeted rate. Instead, it uses open market operations to push the fed funds rate to its target. 

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. Since 2015,  the Fed has been raising interest rates. It does this to control inflation.

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 for inflation is the core inflation rate. The critical indicator for recession is the durable goods report.

It can take 12 to 18 months for a fed funds rate change 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. As a result, they lend less money out. The money they do lend will be at a higher rate. That's because they are borrowing money at a higher fed funds rate to maintain their reserves. Since 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. They use these loans to buy home improvements and new cars. These actions stimulate the economy.

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

A one-fourth point increase in the fed funds rate will curb inflation. But it 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 about what the Fed will do.

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. It's what the Fed charges banks to borrow from it directly through the discount window. It created an alphabet soup of programs to fight the financial crisis.  Most of these are no longer needed.

The Fed uses these tools to control the nation's money supply. Some critics falsely argue that the Federal Reserve is printing money.