Federal Funds Rate: What It Is, How It’s Determined…

What Is the Federal Funds Rate?

The term federal funds rate refers to the target interest rate range set by the Federal Open Market Committee (FOMC). This target is the rate at which commercial banks borrow and lend their excess reserves to each other overnight.

The FOMC, which is the policymaking body of the Federal Reserve System, meets eight times a year to set the target federal funds rate, which is part of its monetary policy. This is used to help promote economic growth.

Understanding the Federal Funds Rate

The federal funds rate refers to the interest rate that banks charge other institutions for lending excess cash to them from their reserve balances on an overnight basis.

By law, banks must maintain a reserve equal to a certain percentage of their deposits in an account at a Federal Reserve bank. The amount of money a bank must keep in its Fed account is known as a reserve requirement and is based on a percentage of the bank’s total deposits.

Financial institutions are required to maintain interest-bearing accounts at Federal Reserve banks to ensure they have enough money to cover depositors’ withdrawals and other obligations. Any money in their reserve that exceeds the required level is available for lending to other banks that might have a shortfall.

The Effective Federal Funds Rate Since 1954

The Fed lowers interest rates in order to stimulate economic growth, as lower financing costs can encourage borrowing and investing. However, when rates are too low, they can spur excessive growth and subsequent inflation, reducing purchasing power and undermining the sustainability of the economic expansion. When there is too much growth, the Fed can then raise interest rates in order to slow inflation and return growth to more sustainable levels.

The Bottom Line

The federal funds rate is used by the Fed to control monetary policy and is watched closely by investors to gauge how the market may move in the future. The rate is one of the most important pieces of financial data in the U.S.

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