Federal Funds Rate

Overview of the Federal Fund Rate

What are Federal Funds?

All commercial and thrift banks are required to keep a certain percentage of deposits, as cash, at their district Federal Reserve Bank. This reserve is known as federal funds and is a safety measure put in place to keep stability in the banking system in the case of a financial crisis where there is a run at the banks. Federal funds are non-interest bearing and usually average 10% of the banks deposits over the past 14 days. Banks, usually smaller thrifts, who are not able to meet the reserve requirements look to other institutions which have excess reserves for a loan at a negotiated interest rate.

What is the Federal Funds Rate?

The federal funds rate is then the average interest rate at which banks loan each other money. CNBC may report that Ben Bernake (Federal Reserve Chief) is lowering the federal funds rate by 50 basis points; this refers to the nominal rate set by the Fed. The Fed can only make a suggestion as to what the fed funds rate should be; lenders will use this as a guide but supply and demand factors will drive the true rate.

What are the impacts of increasing or decreasing the federal funds rate?

The federal funds rate controls the available supply of funds in the market. Raising the federal funds rate makes it more difficult to investors to borrow money and keeps inflation controlled. Tightening the rates has the opposite effect. It allows for more borrowing and economic growth and therefore more inflation. There is a fine line that the Fed must walk to ensure the economy stays in balance.


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