How Does the Fed Funds Rate Work, and What Is Its Impact?

The effective Federal Funds Rate (FFR, or fed funds rate) is the average interest rate that banks pay for overnight borrowing in the federal funds market. The Federal Reserve uses certain tools to adjust this rate, because it influences other interest rates, such as those you pay on credit cards, mortgages, and bank loans. It also affects the value of the U.S. dollar and other household and business assets. That makes it the most important interest rate in the world.

The Fed sets a target range for the fed funds rate. It has a lower and upper bound.

Rates Affected by the Fed Funds Rate

One of the most significant rates influenced by the fed funds rate is the prime rate. That's the prevailing interest rate that banks charge their best customers. The prime rate affects many consumer interest rates, including deposits, bank loans, credit cards, and adjustable-rate mortgages.

There's a ripple effect on other interest rates, too, such as the Secured Overnight Financing Rate (SOFR). The SOFR is a benchmark rate used by banks to determine interest rates charged on mortgages and other loans and derivatives. The SOFR is replacing the London Interbank Offered Rate (LIBOR).

The fed funds rate indirectly influences even longer-term interest rates. Investors want a higher rate for a longer-term Treasury note. The yields on Treasury notes indirectly drive long-term conventional mortgage interest rates.

How the Fed Uses Its Rate To Control the Economy

The Federal Open Market Committee (FOMC) uses several tools to influence interest rates and the economy. The two tools used to keep the fed funds rate in the target rate range are:

• Interest on reserve balances (IORB): The Fed pays interest on the reserves that banks keep with it.
  
• Overnight reverse repurchases (ON RRP): The Fed sells securities to banks that aren't eligible for interest on reserve balances. It then buys them back at a higher price the next day, essentially paying the bank interest.

The committee sets a target range for the rate and then sets the IORB and ON RRP rates to manage the effective fed funds rate. In turn, banks charge each other interest on loans that reflect these changes. These rates then dictate the rates that banks charge their customers, influencing business and consumer spending.

Influencing the fed funds rate helps the Fed manage inflation, promote maximum employment, and keep interest rates moderate. The FOMC members monitor the core inflation rate for long-term signs of inflation and adjust the rates accordingly.

It can take months for a change in the rate to affect the entire economy. Planning that far ahead has led to the Fed becoming the nation’s expert in forecasting economic performance.

Stock market investors should watch the monthly FOMC meetings very carefully. Analysts pay close attention to the FOMC to try and decode what the Fed will do.

How the Fed Funds Rate Maximizes Employment

It's referred to as "expansionary monetary policy" when the Fed lowers the rate range. Banks then offer lower interest rates on everything from credit card rates to student and car loans.

Adjustable-rate home loans become cheaper, which improves the housing market. Homeowners feel richer and spend more. They can also take out home equity loans more easily, spending that money on home improvements and new cars. These actions stimulate the economy by increasing demand.

Employers must hire more workers and increase production when demand increases. This decreases unemployment, increases consumers' ability to spend, and feeds more demand. The Fed then sets a new target range to keep a healthy level of unemployment and inflation.

For example, the FOMC lowered the target for the fed funds rate to effectively zero in 2020 in an emergency response to the COVID-19 pandemic. This move was an attempt to ease the impact of the pandemic on employment and spending.

How the Fed Funds Rate Manages Inflation

The opposite occurs when the Fed raises rates. This is called "contractionary monetary policy," because it slows the economy. The cost of loans grows higher, resulting in consumers and businesses borrowing less.

Adjustable-rate mortgages become more expensive. Homebuyers may only be able to afford smaller loans, which slows the housing industry. Housing prices go down, and homeowners have less equity in their homes. They may spend less, too, further slowing the economy.

How Fed Funds Work

The Federal Reserve used to require banks to keep a percentage of their deposits on hand each night. This reserve requirement prevented them from lending out every dollar they had and ensured that they had enough cash on hand to start each business day. In 2020, the Fed reduced the reserve requirement ratio to 0%.

Banks can still hold capital in reserves for other banks to borrow from, and the Fed pays them interest on the reserves they keep (the IORB). A bank borrows from another bank's reserve if it is short of cash at the end of the day. That's where the fed funds rate comes in, as the rate that banks charge each other for overnight loans.

The balance kept in reserves are the federal funds, and the fed funds rate is determined by the banks that lend each other money. They base their rates on the IORB and the ON RRP rates, creating the effective federal funds rate, which is the volume-weighted average of all the overnight transactions within the reserves.

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