The Federal Funds Rate is the interest rate at which private financial institutions such as banks lend their reserves held at the Federal Reserve to other financial institutions overnight for short term needs.

A bank or other financial institution lends out most of the money deposited with it but also is obligated by law to keep reserves with the Federal Reserve, the central banking system of the United States. Normally the Federal Reserve expects a bank to keep approximately ten percent of their deposits in reserve to cover unforeseen circumstances. Excess amounts of rserves over the required reserve amount are often loaned on a short term basis to other banks.

For example, when a bank makes a loan to an individual or a business in the normal course of operations, that bank’s reserves are depleted because money is dispensed on its balance sheet. If the bank’s reserve level falls below the legally required level it must add to its reserves to remain compliant with Federal Reserve regulations. The bank will borrow that money from another bank that has a surplus in its Federal Reserve account. The interest rate that the first bank will pay to the second bank in return for borrowing the funds is negotiated between the two banks, and the weighted average of this rate across all banks is the effective federal funds rate. This negotiated effective rate is determined in large part by the actions of the Federal Reserve itself.

The nominal rate is a target set by the governors of the Federal Reserve, which they enforce primarily by open market operations, usually the buying and selling of money in different forms. The most common action is the purchasing or selling of Treasury bills and notes. These acgtions can provide more liquidity to the banks in the Federal Reserve System and with added liquidity the funds rate will generally move down when liquidity is reduced, demand for funds increases and the rate goes up. When the media refer to the Federal Reserve “changing interest rates,” this nominal rate is almost always meant. The target is generally a range, as the Federal Reserve cannot set an exact value through open market operations.

The federal funds target rate is decided eight times each year by the Federal Open Market Committee of the Federal Reserve. Depending on their agenda and economic conditions in the U.S., the committee members will increase the rate, decrease it, or leave the rate unchanged.

This brings us to the question of how the Fed Funds Rate is used in the larger economy.
The Fed Funds Rate is the primary tool that the Federal Open Market Committee uses to influence interest rates and the economy.

Changes in the Fed Funds Rate have far-reaching effects by influencing the borrowing cost of banks in the overnight lending market, and subsequently the returns offered on bank deposit products such as certificates of deposit, savings accounts, and money market accounts. Changes in the Fed Funds Rate and the discount rate also dictate changes in the Prime Rate, which is of interest to borrowers. The Prime Rate is the underlying index for most credit cards, home equity loans and lines of credit, auto loans, and personal loans. Many small business loans are also indexed to the Prime Rate. Normally the Prime Rate has hovered approximately 300 basis points higher than the Federal Funds Rate. So, if the Federal Funds rate is 4.5%, the Prime Rate will be 7.5%.

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