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The Fed Funds Rate – What it is and How it Works

The Fed funds rate is used by the Federal Reserve to control the amount of money that banks can lend. You might think banks would want to lend all the money they can; after all, that’s how they make money right!

In truth, they would if they could. But the Federal Reserve stipulates that all banks keep a minimum amount of cash on hand to cover cash withdrawals. This is known as the reserve requirement.

The reserve requirement must be held by the bank at the close of business each day. In order to meet this requirement banks sometimes have to borrow money from each other. These overnight loans are called Fed funds, and the Fed funds rate is the interest rate banks charge each other for these loans.

How the Fed Funds Rate Affects You?

You might think all this dealing between banks has little to no effect on you, but nothing could be further from the truth.

If the Fed funds rate is set high, it means banks are less likely to borrow money to make up the reserve requirement. This in turn means they are less likely to loan money out and when they do, it will be at a higher rate. This makes mortgages more expensive for homebuyers, and loans more expensive for businesses.

When the Fed raises the Fed funds rate, economists call it a contractionary monetary policy. Because the increase in rates makes other loans and mortgages more expensive, so less people buy homes and business are less likely to borrow. This causes the economy to contract.

The opposite is true when the Fed funds rate is decreased. Lending becomes cheaper, meaning banks are more likely to loan money to each other to cover reserve requirements, so more money is available to be loaned out at cheaper rates.

This makes mortgages cheaper, so more people will look to buy a home, which puts pressure on house prices, and businesses will be much more likely to borrow money to fund growth. Economists call this expansionary monetary policy.

 

How the Fed Funds Rate is Set?

The Fed funds rate is actually a weighted average of interest rates that banks charge each other. The Fed has no direct control over this rate but it can influence it.

Each month the Federal Open Market Committee (FOMC), which is the is the monetary policymaking body of the Federal Reserve, releases the Federal funds target rate. This is the rate the Fed wants banks to charge each other. So how does the Fed make sure the actual Fed funds rate, stays near the target rate?

Well, if the FOMC lowers the Fed funds target rate, it backs this up by buying securities on the open market. These securities are paid for by crediting the reserve accounts of the banks which sold them.

This extra cash in the bank’s reserve accounts, means there is less pressure on them to borrow money to make up their minimums. This reduces their need to borrow from other banks and therefore the actual Fed funds rate falls, due to a lack of demand.

If on the other hand the Fed raises the target rate, they sell the banks Government securities and withdraw the money from their reserve accounts. This reduces the amount of money in their reserve accounts, increasing pressure on them to borrow from other banks to make up their reserves, thus raising the actual Fed funds rate.

 

How is the Fed Funds Rate Useful to You as an Investor?

The Fed funds rate is the primary tool used by the Fed to control expansion (inflation) and deflation (recession) in the economy. For example, if the FOMC notices the economy is growing too fast, they can raise the Fed fund target rate to slow down lending and put a brake on inflation.

I theory this sounds simple, but in reality it can take a year or more before the rate change is felt by the economy. In other words, the FOMC needs to think at least 12 months in advance.

This can be an advantage to you as an investor, by keeping an eye on monthly FOMC meeting notes, you can get an idea where the economy is heading. For instance, if the FOMC lowers the Fed funds target rate by ¼ point, the market is likely to respond accordingly and begin to grow.

 

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David Waring

David Waring was the founder of LearnBonds.com and has been a major contributor to the extensive library of investing news and information available on the site. Until the launch of Learnbonds.com in late 2011 there was no single site on the internet catering exclusively to the individual bond investor. This was true even though more individuals own stocks than bonds. Learn Bonds was launched to fill that gap.