What is the ‘Federal Funds Rate’
The federal funds rate is the rate at which depository institutions (banks) lend reserve balances to other banks on an overnight basis. Reserves are excess balances held at the Federal Reserve to maintain reserve requirements.
The fed funds rate is one of the most important interest rates in the U.S. economy since it affects monetary and financial conditions, which in turn have a bearing on critical aspects of the broad economy including employment, growth, and inflation. The fed funds rate also influences short term interest rates, albeit indirectly, for everything from home and auto loans to credit cards, as lenders often set their rates based on the prime lending rate. The prime lending rate is the lending rate at which banks charge their customers. The Federal Open Market Committee (FOMC) meets eight times a year, to set the fed funds rate, and uses open market operations to influence the supply of money to meet the target rate. A calendar of upcoming and past meetings as well as press releases from those meetings can be found here.
BREAKING DOWN ‘Federal Funds Rate’
The FOMC increases the fed funds rate by decreasing the money supply in the system which pushes interest rates higher. This lowers the market equilibrium level of supply and demand for money. This is referred to as contractionary monetary policy. The fed funds rate is lifted in times of economic expansion and is used to cool inflation. On the contrary, the FOMC will increase the money supply to lower the target rate when the economy is sluggish, and inflation is benign. This is referred to as expansionist monetary policy.
Banks and other depository institutions maintain accounts at the Federal Reserve to make payments for themselves or on behalf of their customers. The end-of-the-day balances in these accounts are used to meet the reserve requirements mandated by the Federal Reserve. If a depository institution expects to have excess end-of-day balance than it needs, it will lend the excess amount to an institution that expects to have a shortfall in its balance. The federal funds rate thus represents the interest rate charged by the lending institution.
The target for the federal funds rate – which as noted earlier is set by the FOMC – has varied widely over the years in response to prevailing economic conditions. While it was as high as 20% in the early 1980s, the rate has declined steadily since then, and in 2008, to tackle the Great Recession, the Federal Reserve entered uncharted territory.
Zero Interest Rate Policy
In response to the Great Recession, the Federal Reserve slashed the fed funds rate to a record low of zero (target of 0 to 0.25%). In the space of 12-months, the fed funds rate was reduced by 425 basis points. As the U.S. worked its way out of recession the fed funds rate remained at zero for nine years as policymakers remained cautious. It wasn’t until December 2015, when Fed Chairperson Janet Yellen and the committee shifted the target rate higher for the first time since 2006. In January, 2018, President Trump chose to replace Yellen as Fed Chairperson and nominated Jerome Powell as Chairman of the FOMC. Powell and the FOMC have continued to raise rates and have signaled further increases through 2018.
Global Policy Rates
Benchmark interest rates around the world are different for different countries and economies. The European Central Bank (ECB) sets three separate policy rates; a deposit rate, a refinancing rate, and a marginal lending rate. The Bank of England (BoE) sets a base rate and the Bank of Japan (BoJ) sets a short-term interest rate.