What Are Fed Funds? How the Funds Market Works

The Secret to How the Fed Controls Interest Rates

Fed Funds
Fed funds are the loans banks make to each other to meet the Fed's reserve requirement. Photo: Sorbetto/Getty Images

Definition: Federal Reserve funds are overnight loans banks use to meet the reserve requirement at the end of each day. The Federal Reserve uses the fed funds to control the nation's interest rates. That is because banks borrow fed funds from each other. They pay an interest rate that they call the fed funds rate. The borrowing bank does not need to supply collateral for the loan. The fed funds market is the total amount borrowed by all banks.

The Federal Reserve Open Market Committee sets the rate's target at its regular meetings. A high fed funds rate means banks will lend less. That is because it costs more to borrow enough fed funds to meet the reserve requirement. Interest rates will be high as a result. A low fed funds rate means banks will lend more. That allows them to charge a lower interest rate.

Banks can also borrow from the Federal Reserve's discount window. That interest rate, known as the Federal discount rate, is usually 0.5 percent higher. That encourages banks to borrow fed funds from each other.

How the Fed Funds Market Works

At the end of each day, banks with reserves more than the requirement, lend them to banks that are short. The borrower can hold the funds in its vaults, or at a Federal Reserve Bank. Either way, it counts to meet the bank's reserve requirement.

Even though it's a loan, the lending bank is engaged in a fed funds sale.

Similarly, the borrowing bank is making a fed funds purchase. 

The reserve requirement doesn't apply to small banks ($14.5 million net transactions or less). They ordinarily have a relationship with a larger bank to lend it the amount it needs. That gives the smaller bank a bit of a competitive advantage because it can earn extra interest on its funds.

 

Trends

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 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. (Source: "Who's Lending in the Fed Funds Market?" Liberty Street Economics, December 2, 2013.)

How the Fed Funds Affects the Economy and You

The Federal Reserve sets the reserve requirement in order to control the amount of money available to lend. That’s known as liquidity. The requirement keeps banks from lending out all their money. The Fed requires that a certain percentage of the bank's deposits need to be reserved each night. 

The fed funds rate target is the interest charged for fed funds loans. Both the fed funds rate and the reserve requirement are methods of implementing monetary policy. That is how central banks, like the Fed, manage the money supply to achieve healthy economic growth.

 Their goal is to prevent high inflation at all costs.To find out why this is so important, see How Does Inflation Affect Me?

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? 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. For more, see When Will the Fed Raise Rates?

Expansionary monetary policy spurs economic growth by making it cheaper to borrow. Consumers can borrow more, so 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. For more, see How Does the Fed Lower Interest Rates?

Economic expansion and contraction are part of the business cycle. The Fed uses its monetary policy tools to keep the economy in the expansion phase.