What is the federal funds rate?
The federal funds rate, or federal 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 activity, small changes in the federal funds rate can have a significant impact on financial and economic activity.
When you hear about an interest rate increase or decrease in the news, it’s often because the US Federal Reserve has raised or lowered its federal funds rate target.
As the central bank of the United States, the Federal Reserve influences the federal funds rate as part of its broader efforts to influence monetary policy and economic activity.
To begin with, it is important to understand that regulated depository institutions must maintain an approved amount of cash as “reserves” to protect the financial system. These can be unused “safe cash” but also electronic funds held directly by the Fed in reserve accounts.
Technically, the Federal Reserve does not have the power 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 harder or easier for banks to meet their reserve requirements.
If he wants to make things easier, he can offer to buy back more US Treasuries from banks – giving them the capital they need without interbank lending. If he wants rates to rise to his current fed funds target, he’ll stop buying so many Treasuries and force the banks to depend on lending to each other (and the associated overnight interest rates ) to meet these mandatory reserves.
The effective federal funds rate is the actual rate at which depository institutions lend to each other, which differs from the “target” federal funds rate published by the Federal Reserve.
Sometimes the effective funds rate differs slightly from the target rate based on day-to-day specifics, and other times it diverges because banks are anticipating a significant change or reacting to extreme market conditions.
It should also be noted that following the 2008 financial crisis, the Fed set its “target” rate in a range between zero and 0.25% and the effective rate was expected to float somewhere within this range. For example, in August 2010, the effective federal funds rate was around 0.19% due to global uncertainty that caused real lending rates to be at the top 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 change hands in interbank lending, usually because institutions need more capital to meet their regulatory requirements. So 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% on overnight lending just to meet its regulatory requirements, it must charge at least 1% on every business or consumer loan if it wants to meet the break even. And if he wants to invest in the future or generate significant profits for shareholders, he will probably have to charge a lot more than that.
Again, the Fed can’t even impose a fixed fed funds rate, let alone require mortgage lenders or credit card companies to quote a specific number. It only sets a target, and only for day-to-day lending between banks. But changes to this target change the rates for nearly every other loan in the economy, big or small.
The mandate of the central bank Congress is twofold: to support a maximum of jobs and to support price stability. The Federal Reserve has several tools to influence monetary policy in service of these goals, and changes to the federal funds rate are one of the most important.
Indeed, changes in interest rates change the cost and frequency of loans. Lower rates make it easier for businesses and consumers to purchase big-ticket items on credit, while higher rates make such purchases more difficult.
It may seem counterintuitive for the Federal Reserve to want people to buy less. But as we saw in 2022 with record inflation rates due in part to pent-up pandemic demand, slowing the pace of spending is sometimes in the best interest of long-term economic stability. Basically, that’s why the Fed raised rates recently.
The recent series of rate hikes in 2022 is perhaps the most notable series of changes to the federal funds rate in more than a decade. The Fed’s decision in July to raise its federal funds target to 2.25% from 2.50% marked the fourth increase already in 2022. Additionally, based on public central bank statements and forecasts of On Wall Street, the fed funds rate is expected to top 3.25% by the end of 2022 – a huge shift from the near-zero federal funds rate target of 2008 to 2015 .
This type of rapid and sustained rate increase is not unprecedented, however. A rate of around 3% is also not particularly high from a historical point of view. Consider that in 13 months in 1994 and 1995, the Federal Reserve raised rates seven times amid fears of an overheating economy causing inflation. Specifically, the federal funds rate nearly doubled from 3.05% to 6.05%.
There are also older, even more extreme examples, including unprecedented Federal Reserve actions in the 1970s that briefly spiked the federal funds rate to 20%. That’s more than some less creditworthy consumers are charged for their credit cards. However, just as the global economy was very different before smartphones and email, it should be noted that monetary policy and economics were very different disciplines about 50 years ago.
It is perhaps unsurprising that the seesaw nature of the US economy means a similar ebb and flow in interest rates as the Fed reacts to current market conditions.
In 2007, before the financial crisis, the federal funds rate was 5.25% before being cut to near zero in an effort to prop up the nation in the wake of the Great Recession.
Before that, following the dot-com crisis of 2000, interest rates had been lowered from 5.75% to 1.25% in about two years.
However, not all interest rate cuts are in response to a dramatic economic crisis. The Federal Reserve cut rates from over 9% in 1989 to a brief low of less than 3% in 1993, as part of Chairman Alan Greenspan’s “Great Moderation,” which included steady growth, falling unemployment and subdued inflation in a generally weak period. economic volatility.