Federal Funds Rate

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Definition of the Federal Funds Rate:

The federal funds rate is the Federal Reserve’s target rate for overnight loans between banks.

Detailed Explanation:

Banks are required to maintain a minimum reserve of approximately 10 percent of their deposits. Reserves can drop to abnormally low levels when a bank lends more than anticipated or has large unanticipated withdrawals. Normally banks consider two options: borrowing from another bank or going to the Federal Reserve’s discount window for a loan. 

Imagine you manage Cloudy Bank. At the end of the day, you realize your reserves are inadequate, meaning they are less than the required reserves. You know that Windy Bank has a lot of excess reserves. Windy Bank has been accumulating reserves because its management anticipates closing some large loans within the next few days. What would you do? One solution is to borrow some of Windy Bank’s excess reserves on an overnight basis. Windy Bank likes that idea because these reserves would earn interest.

Daily, banks with excess reserves lend to banks short of funds rather than letting the reserves sit idle and not earn any interest. The Federal Open Market Committee (FOMC) sets a target rate for these overnight loans between banks. (The FOMC is the committee of the Federal Reserve that establishes the country's monetary policy.) This rate is the federal funds rate and is determined by the law of supply and demand. The FOMC manipulates the federal funds rate by adding or subtracting reserves in the banking system. Adding reserves reduces the federal funds rate, in the same way, that an increase in the supply of a good decreases the equilibrium price. Reserves are added to the banking system through the purchase of government securities in the open market. This strategy is referred to as "accommodating" because rates fall and lenders are more accommodating in making loans. It is used when the Federal Reserve wants to accelerate economic growth. Conversely, the FOMC may choose to raise the federal funds rate when the economy is heating up and inflationary pressures mount. They do this by reducing the banking reserves through the sale of government securities. 

Returning to our example, assume you manage Cloudy Bank and the bank is in financial trouble. Other banks are fearful you will be unable to repay them and choose not to lend to you. Where do you go? You can go to your local Federal Reserve Bank and borrow from their “discount window”. The discount rate is the interest rate the Federal Reserve Banks charge when commercial banks and other depository institutions borrow from the Fed. The Federal Reserve requires collateral, such as treasury bonds or other government securities, when making these loans. 

Federal Funds Rate Chart,
Source: Federal Reserve Releases

The graph above illustrates the relationship between the discount rate and federal funds rate from 2003 through 2016. The discount rate is normally set higher than the federal funds rate since the FOMC wants to discourage banks from using the discount window. This changed during the Great Recession in 2008 when the Fed wanted to quickly add liquidity to the economy. Between 2007 and 2008 visits to the discount window at the Philadelphia Federal Reserve Bank increased from just under $1 billion dollars to $2.3 trillion.  Read the Philadelphia Federal Reserve Bank to learn more about borrowing from the discount window during the Great Recession.

Dig Deeper With These Free Lessons:

Monetary Policy – The Power of an Interest Rate
Business Cycles
Aggregate Supply and Demand – Macroeconomic Equilibrium
Fractional Reserve Banking and The Creation of Money

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