The Fed might feel like it’s on a bridge over troubled waters right now.
What is the effective federal funds rate?
The effective federal funds rate is the interest rate banks charge each other for overnight loans to meet their reserve requirements. Also known as the federal funds rate, the effective federal funds rate is set by the Federal Open Market Committee, or FOMC. The effective federal funds rate is the most influential interest rate in the nation’s economy. It affects employment, growth and inflation.
Banks and other depository institutions in the United States maintain accounts at the Federal Reserve. These accounts are largely how banks and other lending institutions make payments for themselves or on behalf of their customers. Only the most creditworthy institutions can borrow overnight funds at the effective federal funds rate.
The Federal Reserve sets reserve requirements for its accounts. Banks often hold their reserve funds at the Federal Reserve. If an institution has a larger end-of-day balance than is required, it will lend funds overnight to other institutions that need it, and charge the effective federal funds rate.
The effective federal funds rate peaked at 20 percent in the 1980s and plunged to zero percent in 2008.
Effective federal funds rate example
Changes in the effective federal funds rate have a broad impact on the U.S. economy. When the real estate market tanked in 2007 and the economy went into a recession, the Fed lowered the cost of borrowing for banks. Banks, in turn, lowered their consumer interest rates for mortgages, auto loans, credit cards and other credit lines, to help stimulate the economy.
Now that the economy has markedly improved, the Fed is gradually raising the federal funds rate again. The current effective federal funds rate is the basis for The Wall Street Journal prime rate, which is a key rate for borrowers. When the Fed raises rates, the Journal’s prime rate also rises, influencing the cost of buying or refinancing a home, taking out a personal loan or other credit.