What is the Federal Funds Rate?
The federal funds rate is the interest rate banks charge each other on loans used to meet reserve requirements. The federal funds rate is often confused with the discount rate, which is the interest rate the Federal Reserve charges on loans directly from the Federal Reserve Bank. But they are not the same.
How Does the Federal Funds Rate Work?Banks derive income from loans and it is beneficial to them to loan out as much as possible. But if a 'run on the bank' occurs and a large number of depositors suddenly want to withdraw their money, the bank risks failure because it lacks the actual cash to pay all depositors at once. To prevent the chaos that would naturally occur in this situation, the Federal Reserve maintains a fractional reserve banking system. The fractional reserve banking system requires banks to keep a certain percentage of their deposits liquid to accommodate withdrawals from a normal number of depositors at any given time.
An increase in the federal funds rate discourages banks from borrowing to meet reserve requirements, which encourages them to build up reserves and lend out less money. A reduction in the overnight rate has the opposite effect: it encourages banks to borrow to meet reserve requirements, which makes more money available for lending. Because the increase in the supply of funds available for lending puts downward pressure on interest rates, changes in the overnight rate can have widespread economic effects.
Why Does the Federal Funds Rate Matter?
Although the Federal Reserve cannot set the federal funds rate, it can manipulate it indirectly. This is primarily done by changing the 'discount rate,' which is set directly by the Federal Reserve. If the discount rate is lower than the federal funds rate, banks will probably prefer to borrow from the Federal Reserve when they need loans. This puts downward pressure on the federal funds rate. Conversely, if the discount rate is higher that the federal funds rate, banks will probably borrow from each other rather than from the Federal Reserve. This puts upward pressure on the federal funds rate. In either case, the Federal Reserve can trigger a change in the federal funds rate by changing the discount rate. This is why the discount rate and the federal funds rate are generally closely correlated.
Manipulation of the federal funds rate is one of three primary methods the Federal Reserve uses to control the money supply. The other two involve changing reserve requirements and buying or selling U.S. Treasuries on the open market.