What is the Fed Funds Rate?

Published by Thomas Herold in Banking, Corporate Finance, Economics

'Fed Funds Rate' is explained in detail and with examples in the Economics edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.

Fed Funds Rate refers to the most key interest rate benchmark in the United States. Such a benchmark rate is the one which the banks charge one another in order to borrow money from each other overnight. The Federal Reserve similarly deploys this rate as a tool in order to meaningfully impact monetary policy within the country. This is not the only benchmark rate in America today, yet it has no rival for importance.

The way the Federal Reserve is able to influence banks with it is somewhat complicated. The commercial banks must maintain a minimum level of money either in cash funds or with their particular regional branch of the Federal Reserve on deposit. The idea behind this is that it allows banks to meet customer withdrawals from their current accounts, including both checking and savings.

Sensible banks hold more than this bare minimum. They keep an excess of the reserves that the regulations and rules pertaining to the banking universe require. These are appropriately referred to as excess reserves. It is such excess reserves that the Fed Funds Rate directly affects.

As the better prepared banks keep plenty of excess reserves available, they are able to overnight loan out to the less prepared banks so that they can end business day operations at their legally required minimum obligation. This unsecured overnight loan occurs at the Fed Funds Rate. It represents the effective rate that the lending bank will charge the borrowing bank.

In nearly all cases, this Fed Funds Rate proves to be the lowest practical interest rate in the nation. Since the financial crisis, it has remained at slightly higher than zero percent. The Federal Reserve began increasing it with their first rate hike in December of 2015, both slowly and gradually.

This rate matters for more reasons than just the price at which a lending bank will charge a borrowing bank to utilize its excess reserves. The reason is that the Federal Reserve is able to set their monetary policy with the rate. As an example, they might decide they need to cut the effective rate of unemployment in the U.S. This is one of their two reasons for existing (along with keeping inflation low). In order to increase employment opportunities, the Fed will push down the Fed Funds Rate through purchasing securities off of commercial banks. As bank reserves go up, the price for them declines. This is their means for pushing down the federal funds rate.

A lower Fed Funds Rate means that banks try to find better opportunities to engage their excess reserves. They might do this by loaning out the money to individuals who seek to purchase a house. They could also lend the cash to companies interested in expanding their business. Either of these actions will boost the economy in some meaningful way. A more active economy will create more jobs and drive down the unemployment rate.

Besides this, the banks also employ the Fed Funds Rate as their basing benchmark from which they determine their other key interest rates. Once the Federal Reserve boosted their federal funds rate target back in December of 2016 as an example, each of the main banks in the country instantly increased their prime loan lending rates. These represent those rates which they offer to their best customers who are extremely creditworthy. The best customers are usually the large and economically powerful MNC multinational corporations.

This means that the effective Fed Funds Rate is not simply the one that the banks are paying each other when they borrow excess reserves from one another. Instead, it has a dramatic and literal connection to the rate of interest any individual will pay for a car loan, home equity loan or line of credit, and mortgage. It also impacts the price that companies will pay to build and grow their business using bank loans.

Free Download (No Signup Required) - The 100 Most Important Financial Terms You Should Know!
This practical financial dictionary helps you understand and comprehend the 100 most important financial terms.

The term 'Fed Funds Rate' is included in the Economics edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.