Federal funds are reserves held in a bank's Federal Reserve account. If a bank holds more than the reserve requirement at the end of each day, it can lend it to a bank that doesn't have enough. Most fed funds transactions are overnight and collateral-free. Since there is no collateral, both banks have high levels of mutual confidence.
The fed funds transaction, although it behaves as a loan, is technically a sale. The "lending" bank charges a small fee. This is the federal funds effective rate. The Federal Reserve uses this rate to control the nation's interest rates.
The Fed uses open market operations to encourage banks to meet this target. It buys securities, replacing them with credit, and giving banks more fed funds to lend. When it wants the effective rate to rise, it removes credit from the banks, replacing it with securities.
A high fed funds rate means interest rates will be high as a result. A low fed funds rate encourages lending because interest rate are lower.
How the Fed Funds Market Works
At the end of each day, banks with reserves greater than the reserve requirement lend the excess to banks that don't have enough on hand to meet the requirement. The reserve requirement is a percentage of the bank's deposits.
A bank must have enough in its vaults or at a Federal Reserve Bank each night to meet the reserve requirement. Banks that don't have enough borrow fed funds from banks that have more than the reserve requirement.
Banks can also meet the overnight requirement by borrowing from the Federal Reserve's discount window. That interest rate, known as the Federal discount rate, is usually higher than the fed funds rate. That encourages banks to borrow fed funds from each other.
The fed funds market has been shrinking ever since the 2008 financial crisis. In 2007, banks lent $200 billion. In 2012, it was only $60 billion. What happened?
First, the Federal Reserve increased its balance sheet to $4.5 trillion through quantitative easing. The Fed bought U.S. Treasurys and mortgage-backed securities from banks. That left them with lots of reserves on their balance sheets.
Second, the Fed now pays banks interest on excess reserves. Banks have less incentive to lend excess fed funds.
On March 15, 2020, the Fed announced it had reduced the reserve requirement ratio to zero effective March 26, 2020. It did so to encourage banks to lend out all of their funds during the COVID-19 coronavirus pandemic.
The fed funds market was created by New York City banks in the 1920s. Before then, banks that didn't have enough funds to meet the reserve requirement had to borrow from the Fed's discount window. Banks with excess funds had no way to earn interest.
To overcome this, bank managers agreed to exchange drafts drawn on Federal Reserve balances. Most transactions were small.
In the late 1920s, the Federal Reserve wire transfer system made larger transactions possible. Fed funds trading ended during the Great Depression as banks needed to hold onto all their cash to protect against bank runs.
After World War II, small banks found it again profitable to lend their excess reserves. Large banks became more likely to be borrowers. High interest rates in the 1960s and 1970s created the incentive that encouraged the fed funds market to expand to current levels.
How the Fed Funds Affects the Economy and You
The Fed uses the fed funds, the fed funds rate, and the reserve requirement to manage liquidity. Its goal is to prevent high inflation at all costs. Inflation hurts the economy by lowering the standard of living.
If inflation is under control, then the Fed has a secondary goal. It must reduce unemployment to its natural level. If unemployment is too high, then the country is probably in a recession.
How does the Fed do this? Expansionary monetary policy spurs economic growth by making it cheaper to borrow. Consumers can borrow more. They will buy things that require loans, like housing, automobiles, and even furniture. Businesses respond to the demand by taking out loans of their own, expanding companies, buying equipment, and hiring more people. Being aware of how the Fed raises or lowers interest rates will give you a better grasp of monetary policies.
Now that the Fed has set the reserve requirement to zero, interest rates should remain at record lows.
To reduce inflation, the Fed raises the fed funds rate. That reduces the amount of money that banks have to lend. That slows consumer borrowing and demand. It also reduces business expansion, investment, and hiring. That's called contractionary monetary policy. It is beneficial to know when the Fed will raise rates.