The fine print appears murky, and its implementation will be rife with challenges.
What is the federal funds rate?
The federal funds rate is the interest rate banks charge each other for overnight loans to meet reserve requirements. If a bank can’t meet its reserve requirements, it can borrow money from the Federal Reserve or from other banks that hold funds at the Fed. This is separate from the discount rate, the rate that the Fed charges for overnight loans.
The Federal Reserve requires banks and other financial institutions to hold a certain amount of money in reserves at the end of each business day to ensure customers can access their funds and to protect against bank failures. This is referred to as the reserve requirement. The reserve requirement is approximately 10 percent of the deposits made at a financial institution. For example, if a bank has deposits of $100,000,000, the bank’s overnight reserve requirement would be roughly $10,000,000.
Banks frequently hold their reserve requirements at the Federal Reserve. Money that is held at the Federal Reserve is referred to as federal funds. The federal funds target rate is the interest rate set by the Fed’s monetary policymaking body, the Federal Reserve Open Market Committee (FOMC), at its eight annual policy meetings. The federal funds effective rate is the actual rate of interest banks charge each other for loans to meet reserve requirements.
The Fed has a few different methods for influencing the federal funds rate. Most commonly, the Fed engages in open market operations by purchasing or selling government bonds and other securities. This increases or decreases the amount of money that circulates in the U.S. economy. It also helps manage the federal funds effective rate.
The Fed can raise or lower the discount rate to influence the federal funds effective rate rate. For example, if the economy needs to be stimulated, it may lower the discount rate. If banks can borrow money from the Fed at a lower rate, this encourages them to lower the rates offered to their customers.
Lastly, the Fed can adjust banks’ reserve requirements. Increasing or reducing the amount of money banks are required to hold in reserves increases or reduces the amount of money they have to lend.
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Federal funds rate example
The Fed uses the federal funds rate to control inflation and encourage healthy economic growth. A lower federal funds rate allows banks to borrow money at lower interest rates and pass on the savings to consumers in the form of lower-priced mortgages, auto loans and other lines of credit. These reduced rates help increase consumer spending. As the cost of adjustable-rate mortgages decreases, homes become less expensive, which stimulates the housing market. The rates charged on credit cards fall, encouraging more consumption.
A higher federal funds rate makes it more expensive for banks to borrow money. When rates are high, banks lend less money and charge higher interest rates. When loans are more expensive and difficult to obtain, businesses are less likely to borrow. This slows the economy. Adjustable-rate mortgages become more expensive, which weakens homebuyers’ purchasing power. In turn, this slows the housing industry, which can cause housing prices to drop and lower homeowners’ equity. This further slows the economy.