Federal Funds Rate

What is the federal funds rate? The federal funds rate is the overnight lending interest rate banks charge one another to borrow money. Yes, banks do loan money to each other. Why is that? Well, recall that banks make money by taking in deposits and using those deposits to make loans. Banks cannot lend out all of their deposits because they need some funds on hand to settle transactions with other banks, to give to customers, and also to satisfy the Federal Reserve, which requires by law that banks hold a certain percentage of their deposits as reserves.

Prior to 2008, the banks didn't have much incentive to keep excess reserves, reserves above and beyond what was required by law. So the banks tried to keep reserve holdings relatively low. Sometimes, they even fell too low to meet Fed requirements so they borrowed reserves from other banks. Borrowing and lending in the federal funds market established an interest rate or the federal funds rate. The federal funds rate is important because the Fed tries to affect the federal funds rate by conducting something called open market operations, and through this tool, affects credit conditions and the rest of the economy.

However, it's important to keep in mind that while the Fed has considerable control over the federal funds rate, there are lots of different interest rates. In theory, these interest rates move together, and they're affected by the interest rate the Fed does influence. In practice, those connections can be looser or tighter, and that will dictate how good a job or how exact a job the Fed does in steering the economy.