Federal Funds Rate

Federal funds rate is the interest rate at which US banks lend their excess reserves for short periods (usually overnight) to other banks.

The borrowing bank and the creditor bank agree on the interest rate on the loan; the weighted average of the rates for all such transactions is called federal funds effective rate.

Federal funds target rate is determined at a meeting of the Federal Open Market Committee of the US Federal Reserve, which is usually held eight times a year, approximately once every seven weeks. The committee may also hold additional meetings and change the target rate outside its usual schedule.

The Federal Reserve uses open market operations to manage the money supply in the US economy so that the effective rate matches the target. The target value of the rate at which real GDP growth is stable relative to long-term aggregate supply and expected inflation is called the neutral rate on federal funds.

Principle of operation

US banks and savings and loan associations are required to maintain a certain level of reserves in the FED. This level is determined by the volume of assets and liabilities of the depository institution or is set by the FED itself but usually amounts to 10% of the total amount of money in current accounts and time deposits.
If the level of reserves falls below the established norm, the bank must increase reserves to meet the requirements of the regulator (FRS). A bank may borrow from another bank if it has excess reserves. Banks agree on a loan rate with each other, the weighted average of the rates for all such operations is called the effective rate on federal funds.

The target rate set by the FED is achieved through open market operations. Since the FED cannot establish the exact value of the rate using such operations, the real value may fluctuate near the target.

When the Federal Open Market Committee (FOMC) wants to lower interest rates, it increases the money supply by buying government bonds. Other things being equal, interest rates fall. Conversely, when the Committee wishes to raise the rate, it sells government bonds, taking money from these sales out of circulation; ceteris paribus, this leads to an increase in rates.

Banks can also borrow directly from the FED using the so-called accounting window. These loans are subject to revision by the FED, and the discount rate is usually higher than the federal funds rate. This motivates banks to borrow directly from the FED, giving the FED the role of lender of last resort. The confusion between these two types of loans often leads to confusion between the federal funds rate and the discount rate. While the FED’s federal funds rate cannot be set accurately, it can set the exact discount rate.

Federal Open Market Committee sets the target value of the rate at its meetings. The rate is either increased, lowered, or left unchanged depending on the agenda and the state of the US economy. Market expectations for future FOMC decisions based on federal funds rate futures are widely used in financial media.

• Wesley Cook