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 benchmark for interest rates on credit cards, mortgages, and bank loans, and the main tool the nation's central bank uses to influence the U.S. economy. 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 used worldwide by banks to determine interest rates charged on various loans. LIBOR comes in five currencies, including the U.S. dollar, and seven maturities ranging from overnight to 12 months. However, LIBOR is expected to see a phase-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.

Recent Change in Direction

In an emergency response to the global outbreak of the new coronavirus, COVID-19, the Federal Reserve's Federal Open Market Committee lowered the target for the fed funds rate twice in March 2020, dropping it by a total of 1.5 percentage points to virtually zero. 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 15 months.

How the Fed Uses Its Rate to Control the Economy

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. 

When the Fed lowers the rate, it's called expansionary monetary policy. 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.

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.

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. Because loans are harder to get and more expensive, businesses will be less likely to borrow. This reduction in business borrowing 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.

All this means stock market investors watch the monthly FOMC meetings like hawks. Analysts pore over every word uttered by anyone on the FOMC, trying to 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.

Of course, none of the norms apply when a crisis hits, as it did in both 2008 and 2020. The Dow Jones Industrial Average fell almost 13%—the biggest one-day drop ever—after the March 15, 2020 rate reduction signaled that fears about an economic collapse were justified.

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.