Federal Funds Rate: What It Is, How It's Determined, and Why It's Important

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 end-of-the-day balances in the bank's account averaged over two-week reserve maintenance periods are used to determine whether it meets its reserve requirements. If a bank expects to have end-of-the-day balances greater than what's required, it can lend the excess to an institution that anticipates a shortfall in its balances. The interest rate the lending bank can charge is the federal funds rate, or fed funds rate.

The FOMC makes its decisions about rate adjustments based on key economic indicators that may show signs of inflation, recession, or other issues that can affect sustainable economic growth. The indicators can include measures like the core inflation rate and the durable goods orders report.

The target for the federal funds rate has varied widely over the years in response to the prevailing economic conditions. It was set as high as 20% in the early 1980s in response to inflation. With the coming of the Great Recession, the rate was slashed to a record-low target of 0% to 0.25% in an attempt to encourage growth.

In March 2020, the target rate was between 0% and 0.25%. In 2022, to combat inflation, the Fed started raising its rate, which is a process that continued into 2023. The FOMC said these moves were necessary as indicators show the economy is expanding at a modest pace, job gains have been robust, the unemployment rate has remained low, and inflation remains elevated.

The FOMC increased the target fed funds rate to a range of 5.25% and 5.5% in July 2023. It maintained this range during subsequent meetings and confirmed the range in its last meeting in March 2024, in order to keep in line with its target inflation rate and goal of reaching maximum employment. Although the economy is expanding and unemployment remains low, the FOMC remains cautious about the level of inflation, which remains elevated.

Special Considerations

The FOMC cannot force banks to charge the exact federal funds rate. Rather, the FOMC sets a target rate as a guidepost. The actual interest rate a lending bank will charge is determined through negotiations between the two banks. The weighted average of interest rates across all transactions of this type is known as the effective federal funds rate.

While the FOMC can't mandate a particular federal funds rate, the Federal Reserve System can adjust the money supply so that interest rates will move toward the target rate. By increasing the amount of money in the system it can cause interest rates to fall. Conversely, by decreasing the money supply it can make interest rates rise.

Besides the federal funds rate, the Federal Reserve also sets a discount rate, which is the interest rate the Fed charges banks that borrow from it directly. This rate tends to be higher than the target fed funds rate, partly to encourage banks to borrow from other banks at the lower federal funds rate.

Impact of the Federal Funds Rate

The federal funds rate is one of the most important interest rates in the U.S. economy. That's because it impacts monetary and financial conditions, which in turn have a bearing on critical aspects of the broader economy including employment, growth, and inflation.

The rate also influences short-term interest rates, albeit indirectly, for everything from home and auto loans to credit cards, as lenders often set their rates based on the prime lending rate. The prime rate is the rate banks charge their most creditworthy borrowers—a rate that is also influenced by the federal funds rate.

Investors keep a close watch on the federal funds rate. The stock market typically reacts very strongly to changes in the target rate.

For example, a small decline in the rate can prompt the market to leap higher as the borrowing costs for companies get lower. Many stock analysts pay particular attention to statements by members of the FOMC to try to get a sense of where the target rate may be headed.

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.