Fed Funds (or Federal Funds) are the reserves that depository banks in the United States lend to each other on a very short-term basis, usually overnight. These interbank loans are made on the Federal Funds market to meet the reserve requirements imposed by the Federal Reserve (the Fed), i.e. the minimum amount of reserves a bank must hold at the end of each day to guarantee the stability of the financial system.
The Fed Funds rate
The Fed Funds Rate is the interest rate at which these transactions take place. This rate is set by demand and supply on the interbank market, but is directly influenced by the monetary policy of the US Federal Reserve. The Fed uses the Fed Funds rate as a key instrument to control liquidity in the economy and regulate inflation.
There are two important Fed Funds rates:
- The Fed Funds target rate: This is the range within which the Fed wants banks to lend to each other. The Fed announces this target rate following meetings of the Federal Open Market Committee (FOMC), and it is one of the main tools of American monetary policy.
- The effective Fed Funds rate: This is the average rate actually observed in interbank transactions on a day-to-day basis. It may sometimes diverge slightly from the target rate, but generally remains close thanks to Fed interventions.
How Fed Funds work
U.S. commercial banks must meet minimum reserve requirements, i.e. they must hold a certain percentage of their deposits in the form of reserves with the Federal Reserve or in cash. However, the amounts banks hold in reserves vary throughout the day, depending on banking operations. If, at the end of the day, a bank finds itself with a reserve deficit, it can borrow funds from another bank with a reserve surplus. It is on this interbank market that Fed Funds are traded.
Importance of the Fed Funds rate
The Fed Funds rate is crucial for several reasons:
- Monetary policy: The Fed Funds rate is the Federal Reserve’s main monetary policy lever. By adjusting this rate, the Fed can influence the amount of credit available in the economy, and consequently consumption, investment and economic growth. A low rate encourages banks to lend more, which stimulates growth. Conversely, a high rate puts the brakes on borrowing and can help contain inflation.
- Impact on interest rates: The Fed Funds rate is the basis for many other interest rates, including rates on commercial loans, mortgages, credit cards and auto loans. A rise in the Fed Funds rate generally results in higher interest rates for consumers and businesses.
- Economic indicator: The Fed Funds rate is a key indicator of the health of the economy. When the Fed cuts the rate, it generally means that it is seeking to stimulate a slowing economy. Conversely, an increase in the rate often indicates that the economy is overheating, and that the Fed is seeking to contain inflation.
The Fed and control of Fed Funds
Although the Fed Funds rate is determined by the market, the Federal Reserve actively intervenes to ensure that it remains close to its target. To do this, it uses two main tools:
- Open market operations: The Fed buys or sells securities on the market to adjust the level of reserves available in the banking system. By buying securities, it injects liquidity, thereby lowering the Fed Funds rate. By selling securities, it withdraws liquidity from the system, thereby raising the rate.
- Interest rate on excess reserves (IOER): Since the 2008 financial crisis, the Fed has been paying interest on the excess reserves that banks hold with it. This rate directly influences the Fed Funds rate by encouraging banks to adjust their lending behavior.
Impact on financial markets
The Fed Funds rate has a major influence on financial markets. Fed rate decisions are closely scrutinized by investors and can provoke immediate reactions in the stock, bond and currency markets. An unexpected reduction in the Fed Funds rate can be seen as a boost to the economy and can stimulate equity markets, while an unanticipated increase could dampen investment and cause markets to fall.
