The federal funds rate (abbreviated as “fed funds rate”) is solely utilized between banks; it is not an interest rate that a person may apply for or that a financial account will receive.
How much does the federal funds rate cost?
The federal funds rate, commonly known as the overnight rate, is the amount of interest charged by commercial banks when they lend money to one another for very short periods of time – literally overnight.
This action is required by the Fed in order for banks to satisfy their reserve requirements. That is, every business day, each bank must have enough cash on hand, as well as a reserve balance with the central bank, to cover a specific percentage of its deposits and other liabilities.
These rules are in place to ensure that bank account holders have constant access to their funds. If a bank runs out of cash to meet its reserve requirements, it borrows from another bank at (or very near to) the fed funds rate.
Federal funds rates are divided into two categories:
- The federal funds effective rate is a weighted average of all the interest rates that banks pay to borrow money from other banks across the country.
- The federal funds target rate is the rate set by the Federal Open Market Committee (FOMC), the Federal Reserve’s monetary policy-making body, to serve as a benchmark against which banks charge one another. The FOMC, which is made up of the Board of Governors of the Federal Reserve and the presidents of five regional Federal Reserve Banks, meets at least eight times a year to decide on the federal funds rate depending on current economic conditions.
When individuals say the Fed is “slashing interest rates” or “increasing interest rates,” they are usually referring to the federal funds target rate.
What is the impact of the federal funds rate on the economy?
The FOMC can raise, reduce, or maintain the fed funds rate throughout its eight sessions per year. But what motivates the committee to update it on a regular basis? How does the Fed utilize it to modify the economy?
The Fed reduces the fed funds rate when it wants to boost economic growth (output, expenditure, and expansion). This action lowers the cost of borrowing money and maintaining reserves for banks. As a result, these banks may lend out their excess capital at cheaper interest rates, enabling businesses and individuals to borrow money to develop, invest, and purchase goods. In technical words, it expands the system’s money supply.
When the Fed needs to slow the economy down, such as when prices are rising too quickly and producing inflation, it boosts the fed funds rate. Member banks must pay more interest to keep their statutory reserve level from falling below zero. They subsequently boost their client’s interest rates, which tends to slow down any borrowing activity. When banks stop lending, the money supply shrinks, and economic growth returns to more sustainable levels.
The financial conclusion
The federal funds rate is a key instrument — some would argue the key tool — that the Federal Reserve employs to promote or impede the economy. Not to mention maintaining the nation’s banks’ viability and dependability.
The federal funds rate has an impact on financial institutions and individuals in one way. There’s not much you can do to influence or even predict the Fed’s actions, but it’s important to understand how they affect your everyday life and money.