In the United States, the federal funds rate refers to the interest rate that depository institutions (such as banks and credit unions) charge other depository institutions for overnight lending of capital from their reserve balances on an uncollateralized basis.
Types of Rates
There are two types of federal funds rates: the federal funds effective rate and the federal funds target rate.
The effective rate is calculated as a weighted average of all rates charged by the banks for lending to other banks across the country. Conversely, the target rate is specified by the members of the Federal Open Market Committee (FOMC).
Generally, the federal funds target rate is determined eight times a year, but it may be adjusted more often. The effective and target rates do not always coincide. The Federal Reserve may engage in open market operations (buying or selling the US Treasury securities) to eliminate the discrepancy between the two rates.
The rate is closely related to the concept of reserve requirements. Almost every central bank in the world requires commercial banks in their respective jurisdictions to keep a minimum reserve amount.
Generally, the reserve requirement is a specified percentage of the bank’s total deposit liabilities. The reserve requirement primarily consists of cash physically held by a bank (also known as vault cash) and the bank’s balance held in its account with the central bank.
The purpose of reserve requirements is to cover the possible withdrawals of depositors or any other obligations. If a bank does not currently possess the required amount of money, it can borrow the insufficient amount from another bank or from the Federal Reserve, the central bank.
Alternatively, if a bank holds excess money, it can lend an excessive portion to another bank. The participating banks generally discuss the interest rates that will be charged. Although the banks can charge any interest rate, the rate is typically aligned with the target rate.
The federal funds rate (in this case, the federal funds target rate) is determined by the Federal Open Market Committee, a part of the Federal Reserve System that oversees the US open market operations.
The importance of the federal funds rate cannot be underestimated because the interest rate is a key tool in the monetary policy implemented by the US Federal Reserve System. Since the federal rate regulates the interest amount that banks can charge each other to maintain their reserve balances, it exerts an indirect influence on the interest rates that the banks charge their customers as well.
For example, if the federal funds rate increases, the banks will also charge their clients higher interest rates as well to offset the increased lending costs. By manipulating the target rate, the Federal Reserve can implement either an expansionary or contractionary monetary policy.
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