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

The effective Federal Funds Rate (FFR) is the average interest rate banks pay for overnight borrowing in the federal funds market. The Federal Reserve uses certain tools to adjust this rate because it influences 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 FFR. It has a lower and upper bound. Below are the most recent target ranges announced at Federal Open Market Committee (FOMC) meetings.

Fed Funds Rate from 2019 to 2021
Date	Targeted Fed Funds Rate
Jan. 30, 2019	2.25%–2.50%
March 20, 2019	2.25%–2.50%
May 1, 2019	2.25%–2.50%
June 19, 2019	2.25%–2.50%
July 31, 2019	2.00%–2.25%
Sept. 18, 2019	1.75%–2.00%
Oct. 11, 2019	1.75%–2.00%
Oct. 30, 2019	1.50%–1.75%
Dec. 11, 2019	1.50%–1.75%
Jan. 29, 2020	1.50%–1.75%
March 3, 2020	1.00%–1.25%
March 15, 2020	0%–0.25%
April 29, 2020	0%–0.25%
June 10, 2020	0%–0.25%
July 29, 2020	0%–0.25%
Sept. 16, 2020	0%–0.25%
Nov. 5, 2020	0%–0.25%
Dec. 16, 2020	0%–0.25%
Jan. 27, 2021	0%–0.25%
March 17, 2021	0%-0.25%
April 28, 2021	0%-0.25%
June 16, 2021	0%-0.25%
July 28, 2021	0%-0.25%
Sept. 22, 2021	0%–0.25%

Rates Affected by the Fed Funds Rate

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

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

The FFR 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) uses several tools to influence interest rates and the economy. The two tools used currently to keep the FFR in the target rate range are:

• Interest on reserve balances (IORB): The Fed pays interest on the reserves banks keep with it.
  
• Overnight reverse repurchases (ON RRP): The Fed sells securities to banks not eligible for interest on reserve balances, then buys them back at a higher price the next day—essentially paying the bank interest.

To manage the effective FFR, the committee sets a target range for the rate and then sets the IORB and ON RRP rates, which influence the FFR. In turn, banks charge each other interest on loans that reflect these changes. These rates then dictate the rates that banks charge their customers, which influences business and consumer spending.

Influencing the FFR helps the Fed manage inflation, promote maximum employment, and keep interest rates moderate. The FOMC members monitor the core inflation rate for long-term signs of inflation and adjust the rates accordingly.

It can take months for a change in the rate to affect the entire economy. Planning that far ahead has led to the Fed becoming the nation’s expert in forecasting economic performance.

All this means stock market investors watch the monthly FOMC meetings like hawks. Analysts pay close attention to the FOMC to try and decode what the Fed will do.

How the Fed Funds Rate Maximizes Employment

When the Fed lowers the rate range, 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 by increasing demand.

When demand increases, employers must hire more workers and increase production. This decreases unemployment, increases consumer's ability to spend, and feeds more demand. The Fed then sets a target range to keep a healthy level of unemployment and inflation.

In an emergency response to the COVID-19 pandemic, the FOMC lowered the target for the FFR twice in March 2020, dropping it by a total of 1.5 percentage points to its current rate of near zero. This was an attempt to ease the impact of the pandemic on employment and spending.

How the Fed Funds Rate Manages Inflation

When the Fed raises rates, the opposite occurs. This is called contractionary monetary policy because it slows the economy. The cost of loans grows higher. 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, further slowing the economy.

How Fed Funds Actually Work

The Federal Reserve used to require banks to keep a percentage of their deposits on hand each night. This reserve requirement prevented them from lending out every dollar they had. This ensured they had enough cash on hand to start each business day. As of March 2020, the Fed reduced the reserve ratio to 0%, effectually no longer requiring depository institutions to maintain a reserve balance.

However, banks can still hold capital in reserves for other banks to borrow from, and the Fed pays them interest on the reserves they keep (the IORB). If a bank is short of cash at the end of the day, it borrows from another bank's reserve. That's where the FFR comes in. It is the rate banks charge each other for overnight loans.

The balance kept in reserves are the federal funds, and the FFR is determined by the banks that loan each other money. They base their rates on the IORB and the ON RRP rates, creating the effective federal funds rate, which is the volume-weighted average of all the overnight transactions within the reserves.

The Fed sets its target FFR range, for example, 0%–.25%. This is a 25-basis-point range that the effective FFR will stay within because banks won't want to pay more interest on a loan than they earn on their reserves and reverse repurchases.

If the FOMC wants the rate lower, it set the target rate range lower. This forces the banks to lower their overnight lending rates so they can lend funds to each other.

When the Fed wants rates higher, it does the opposite. It sets the range higher, forcing banks to raise their overnight lending rates.

The Federal Reserve has many other tools they have used in addition to the IORB and ON RRP. In the past, it has directly set the FFR or used open market operations to influence banks to lend. It still keeps several tools available if they are needed; however, it no longer directly changes the FFR. It makes technical adjustments to the administered rates of the IORB and ON RRP to influence FFR changes.