The federal funds rate is the average interest rate banks pay to borrow from each other on an overnight basis.
It’s set by the U.S. Federal Reserve, or The Fed, although that central bank doesn’t actually require banks and lenders to use this rate though. It’s more of a guideline.
Under U.S. law, banks must maintain minimum reserves in proportion to their deposits, which are held at a Federal Reserve Bank. If a bank has excess reserves, it will usually choose to lend those funds to another bank that has a reserve deficit. That’s where the federal funds rate comes in: It’s the overnight rate for interbank loans.
When banks hold capital in reserves for other banks to borrow, the Fed pays them interest on those reserves. This ensures there is an incentive to lend money and keep it circulating in the economy, rather than hoard it in vaults.
Beyond the banks
The federal funds rate is one of the most important interest rates in the U.S. economy. It affects monetary and financial conditions, which in turn influence several important facets of the broader economy, like employment, growth, and inflation.
One of the most key rates influenced by the federal funds rate is the prime rate, which in turn affects many consumer interest rates, such as those paid on deposits, or charged on bank loans, credit cards, and variable-rate mortgages.
The federal funds rate also indirectly influences longer-term interest rates. Investors typically demand a higher rate to lock up their money for longer, as they would, for instance, with a longer-term Treasury note. The yields on Treasury notes indirectly drive long-term fixed mortgage interest rates.
It also affects the value of the U.S. Dollar and other household and business assets.
The fed funds rate may sound like something that only matters to big banks, but a host of interest rates are based on this benchmark, making it an important indicator for individuals as well – because when the rate rises, some consumer loans will become more costly.