This article will be a brief explanation of the federal funds rate. First we will go over the federal reserve system and the reason for the target rate.. Next we will go over how the Federal Open Market Committee pushes the market toward the desired rate. Lastly we will cover the impact the rate can have on the economy, particularly loans and the stock market.
The federal federal reserve requires all banks under its authority to keep a reserve account that is equal to a portion of their deposits at a federal reserve bank. These accounts must maintain the minimum balance on a weekly average basis or face penalties from the federal reserve. Banks that have a surplus can loan that money to banks that need it on a daily basis through uncollateralized loans. The rate at which these loans are made is the federal funds effective rate.
The Federal Open Market Committee (FOMC) sets the federal funds target rate and then manipulates the market to steer the effective rate to the desired target range. The FOMC does not directly dictate the rate the banks may use for the federal funds rate. Instead they adjust the supply of currency in the system to increase or decrease the interest rate’s value. This is generally achieved by buying or selling government bonds to change the money supply in circulation.
Changes to the federal funds target rate can impact the economy in many ways. Even the decision to leave the rate the same will have an impact. For the banking system the federal funds rate acts as a floor for interest rates that they base their own prime rates on. With a low rate the banks can take on more risky opportunities because the profit margin for them is greater. If the rate is raised then the banks will generally reject more risky opportunities because the profit margin is smaller. The stock market too follows the rate with much speculation as to if the FOMC will raise, hold, or cut the rate. The choice of the FOMC many times will indicate the direction the overall market will take for the next month. The rate also influences international markets as when the rate is low we tend to invest more in foreign markets but when the rate is high we turn more inward. A rising rate will also help to raise the value of the dollar making investment by foreign nations less appealing.
The FOMC generally changes the rate to slow the rate of inflation or to reduce the impact of an economic downturn. Since the financial crisis of 2008 the federal fund target rate has stayed between 0% and 2.5%. This is vastly lower than the average rate of around 5% for the last half a century. In the early 80s the rate was even raised as high as 18% to try to slow the rate of inflation back to the desired 2% yearly increase.
One last note, the federal discount rate is often confused with the federal funds rate. The discount rate is the interest rate the federal reserve charges banks that borrow from it. The rate is generally higher than the federal funds target rate to encourage banks to borrow from each other first. The federal reserve is available as a last resort if the other banks will not agree to the loan.