Fed Funds Rate: Definition, Impact and How It Works

US Economy

Updated December 19, 2016

Definition: 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. That's what the nation's central bank require they keep 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 LIBOR, or the London Interbank Offering Rate. That's what banks charge each other for one-month, three-month, six-month, and one-year loans. It also includes the prime 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. Usually, 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 .75 percent. The Federal Open Market Committee raised it on December 14, 2016.

That's a year since its first increase on December 17, 2015. Before this, it was zero to combat the financial crisis of 2008. Former Fed Chair Ben Bernanke lowered it to this level on December 16, 2008. The Fed had aggressively lowered it ten times in the prior 14 months. The highest was 20 percent in 1979.

That's when former Fed Chair Paul Volcker used it as a tool to combat inflation. For more on the Fed funds rate highs and lows, see Historical Fed Funds Rate.

How It Works

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 lent and borrowed is known as the Federal Funds.

The Federal Reserve's Open Market Committee (FOMC) 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 it 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. That means the banks need to lower the Fed funds rate to lend out the extra funds to each other. For more, see How Does the Fed Lower Interest Rates?

When the Fed wants rates higher, it does the opposite. It sells its securities to banks, removing funds from their balance sheet, giving them fewer reserves.

That allows them to raise rates. For more, see When Will the Fed Raise Interest Rates and Who Is Controlling Inflation?

How the Fed Uses It 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 to 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 12-18 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 which 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.

That means they will lend less money out, and 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, thus slowing 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, so homeowners have less equity in their homes and feel poorer. They spend less, 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 rate are low. Credit card rates drop, so consumers shop more. With cheaper bank lending, businesses expand. That's called expansionary monetary policy.

Adjustable-rate home loans become cheaper, so the housing market improves. Homeowners feel richer and spend more. They can also take out home equity loans more easily. They usually use these loans to buy home improvements and new cars, stimulating the economy.

For this reason, stock market investors watch the monthly FOMC meetings like a hawk. A 1/4 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 1/4 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.

Fed Funds Rate, Discount Rate, and Other Tools

The Fed funds rate is the primary tool of the Federal Reserve, but there are others. The Federal Reserve also has a discount rate, which it keeps above the Fed funds rate. That's what the Fed charges banks to borrow from it directly through the discount window.

The Fed also controls the nation's money supply. For more, see Is the Federal Reserve Printing Money?

The Fed created an alphabet soup of programs to fight the financial crisis. For more, see the Federal Reserve Tools.