What is the Federal Funds Rate?
The Federal Funds Rate, or Fed Funds Rate, is the interest rate that US banks charge each other for unsecured overnight loans. Because these short-term loans are a fundamental part of banking operations, small changes in interest rates can have a large impact on financial and economic activity.
When you hear about a rate hike or cut in the news, it’s often because the Federal Reserve has raised or lowered its target for the fed funds rate.
As the central bank of the United States, the Federal Reserve affects the federal funds rate as part of its broader effort to influence monetary policy and economic activity.
First of all, it is important to understand that regulated custodians are required to hold an approved amount of cash as a “reserve” to protect the financial system. This can be unused “vault money” but also electronic funds held in reserve accounts directly by the Fed.
Technically, the Federal Reserve does not have the authority to impose a fixed interest rate on the rest of the financial system. However, it can easily influence the broader interest rate environment by making it more difficult or easier for banks to meet their reserve requirements.
If it wants to make things easier, it can offer to buy back more US Treasury bonds from banks — giving them the capital they need without interbank lending. If it wants rates to rise based on its current federal funding target, it will stop buying as many Treasuries and force banks to rely on each other’s borrowing (and associated overnight interest rates) to meet those reserve requirements.
The effective federal funds rate is the actual rate at which deposit-taking institutions lend to each other, which deviates from the “target” federal funds rate published by the Federal Reserve.
Sometimes the fund’s effective rate deviates slightly from the target rate based on daily specifics, and sometimes it deviates because banks are either anticipating a big change or reacting to extreme market conditions.
It’s also worth noting that during the 2008 financial crisis, the Fed set its “target” interest rate at a range between zero and 0.25%, and the effective interest rate should be somewhere in that range. For example, the effective fed funds rate was around 0.19% in August 2010, thanks to global uncertainty that caused real lending rates to hover at the upper end of this range. By August 2013, they had fallen to just 0.08%, at the lower end of that range.
On an average day, hundreds of billions of dollars in interbank loans change hands – often because institutions need more capital to meet their regulatory requirements. So just a few basis points on these loans can lead to significant behavioral changes.
Think of it this way: if a bank is routinely charged 1% for overnight lending just to meet its regulatory requirements, it must charge at least 1% on every loan to businesses or consumers if it wants to break even. And if it wants to invest in the future or generate significant gains for shareholders, it probably has to ask for a lot more.
Again, the Fed can’t even dictate a fixed rate, let alone require mortgage lenders or credit card companies to offer a specific number. Only one target is set, and only for overnight interbank loans. But the changes to that target move interest rates on almost every other loan in the economy, both large and small.
The central bank’s congressional mandate is two-fold: support maximum employment and support price stability. The Federal Reserve has several tools at its disposal to influence monetary policy in the service of these goals, and changes to the Federal Funds Rate are one of the more important.
That’s because changes in interest rates change the cost and frequency of lending. Lower rates make it easier for businesses and consumers to buy high-priced items on credit, while higher rates make those purchases more difficult.
It might sound counterintuitive if the Federal Reserve ever wants people to buy less. But as we’ve seen in 2022, with record inflation rates driven in part by pent-up pandemic demand, slowing the spending rate is sometimes in the best interests of long-term economic stability. Basically, that’s why the Fed recently hiked interest rates.
The latest round of rate hikes in 2022 is perhaps the most notable series of changes in the fed funds rate in more than a decade. The Fed’s decision in July to raise its Fed Funds target to between 2.25% and 2.50% marked the fourth hike in 2022. In addition, there are public statements from the central bank and Wall Street forecasts Expectations that the fed funds rate could climb above 3.25% by the end of 2022 – a huge change from the Fed’s near-zero interest rate target from 2008 to 2015.
However, this type of brisk and sustained rise in interest rates is not unprecedented. Even a rate of around 3% is historically not particularly high. Consider that the US Federal Reserve raised interest rates seven times over the 13 months of 1994 and 1995 on concerns that an overheated economy could trigger inflation. Notably, the federal funds rate nearly doubled from 3.05% to 6.05%.
There are also older examples that are even more extreme, including unprecedented moves by the Federal Reserve in the 1970s that briefly sent the fed funds rate as high as 20%. That’s more than some less creditworthy consumers pay for their credit cards. But just as the global economy was very different before smartphones and email, it’s worth noting that some 50 years ago, monetary policy and economics were very different disciplines.
Perhaps unsurprisingly, the boom-and-bust nature of the US economy means a similar ebb and flow in interest rates as the Fed responds to current market conditions.
In 2007, before the financial crisis, the fed funds rate was 5.25% before being cut to almost zero to prop up the nation after the Great Recession.
Before that, the dot-com crisis in 2000 saw interest rates cut from 5.75% to 1.25% in about two years.
However, not all interest rate cuts are a reaction to a dramatic economic crisis. The Federal Reserve cut interest rates from more than 9% in 1989 to a brief low of less than 3% in 1993 as part of Chairman Alan Greenspan’s “Great Moderation,” characterized by steady growth, falling unemployment and subdued inflation in the United States characterized by economic volatility during a generally low period.