What is the Fed Funds Rate?

The federal funds rate is the interest rate at which one bank charges another bank for ultra-short-term loans, usually overnight. This rate is a target range set by the U.S. Federal Reserve System (Fed). Banks negotiate the exact rate within this range independently.

Previously, the federal government required banks to hold a certain percentage of deposits as cash reserves. However, in 2020, this requirement was abolished. Until that time, these reserves were held in the Federal Reserve System, often referred to as the "central bank." The U.S. has 12 Federal Reserve Banks that support the system's operations.

Today, banks still keep funds in the Fed, but for a different purpose — managing cash flows. For instance, when a bank moves large sums of money and needs additional liquidity, it can borrow funds from other financial institutions through the Federal Reserve System.

Who sets the federal funds rate?

The Federal Reserve System has a special body — the Federal Open Market Committee (FOMC), which meets eight times a year to set the target range for the rate. At its meetings, the committee decides whether to raise, lower, or leave the rate unchanged.

FOMC decisions are usually widely covered in economic news. You might see headlines like "Fed Raises Rates by a Quarter Point" or "FOMC Lowers Rates."

Why does the Fed change the federal funds rate?

Changing the federal funds rate is one of the Fed's main tools for monetary policy. It aims to regulate the U.S. economy:

• Raising the rate makes loans more expensive, slowing consumer spending and the economy overall, helping to reduce inflation.
• Lowering the rate makes loans cheaper, stimulating economic growth.

This allows the Fed to influence inflation, which is one of the central bank's main objectives.

How does the federal funds rate affect ordinary citizens?

Changes in the federal funds rate impact the entire financial market, including conditions for consumers. For example:

• Interest rates on savings accounts and certificates of deposit (CDs).
• Interest rates on credit cards.
• Interest rates on auto loans and student loans.

Although the federal funds rate does not directly affect mortgage rates, its changes influence the bond market and, consequently, mortgage loan costs.

Why does it matter?

Understanding the mechanics of the federal funds rate helps predict how changes in monetary policy may affect personal finances, loan rates, and overall economic stability.