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Federal Funds Rate: How It’s Determined and Why It’s Important

File Photo: Federal Funds Rate: How It's Determined, and Why It's Important
File Photo: Federal Funds Rate: How It's Determined, and Why It's Important File Photo: Federal Funds Rate: How It's Determined, and Why It's Important

The Federal Funds Rate in definition

The federal funds rate is the FOMC’s target interest rate range. This is the overnight rate at which commercial banks borrow and lend surplus reserves. The FOMC sets the target federal funds rate eight times a year as part of its monetary policy. This boosts economic growth.

Federal Funds Rate Understanding

Banks charge other institutions the federal funds rate for overnight loans of surplus cash from their reserve accounts.

Banks must reserve a specific amount of their deposits in Federal Reserve accounts by regulation. A bank’s Fed account reserve requirement is a percentage of its total deposits. Financial institutions must have interest-bearing accounts at Federal Reserve banks to satisfy depositor withdrawals and other commitments. They can lend to other banks with shortfalls if their reserve exceeds the acceptable amount.

To assess if the bank satisfies its reserve requirements, its end-of-day balances are averaged over two weeks. A bank that predicts higher end-of-day ratios might lend the surplus to a firm that forecasts lower balances. Lenders can charge the federal funds rate. The FOMC bases rate adjustments on economic indicators indicating inflation, recession, or other difficulties that might slow economic development. The hands might include core inflation and durable goods orders.

The Fed Funds Effective Rate from 1954 onwards

Lower finance costs promote borrowing and investing; thus, the Fed reduces interest rates to boost economic growth. Too low speeds can cause excessive growth and inflation, lowering buying power and hurting economic prosperity. The Fed can raise interest rates to decrease inflation and stabilize growth when growth is too high.

Economic factors have changed the federal funds rate goal throughout time. In reaction to inflation, it reached 20% in the early 1980s. During the Great Recession, the rate was cut from a record low of 0% to 0.25% to boost growth.

The Fed began hiking its rate in 2022 to fight inflation, continuing until 2023. The March 2020 target rate was 0%–0.25%. The FOMC last raised the target fed funds rate to 5.25%–5.5% on July 26, 2023. The organization claimed the rise was needed for maximum employment and 2% inflation.

The FOMC took this move because indicators suggest the economy is expanding modestly, job growth is strong, the unemployment rate is low, and inflation is high.

Particular Points to Consider

The FOMC cannot mandate banks’ federal fund rates. The FOMC uses a target rate as guidance. Negotiations between lending institutions set the interest rate. The effective federal funds rate is the weighted average of all such transactions’ interest rates.

The FOMC can’t set a fed funds rate, but the Fed can alter the money supply to shift interest rates toward it. Adding money to the system can lower interest rates. Conversely, reducing the money supply raises interest rates.

The Federal Reserve charges banks that borrow directly from it a discount rate in addition to the federal funds rate. This rate is usually higher than the target fed funds rate to encourage banks to borrow at a lower rate.

Federal Funds Rate Effect

The Fed funds rate is a key U.S. interest rate. It affects monetary and financial circumstances, which affect employment, growth, and inflation.

This indirectly affects short-term interest rates for house, vehicle, and credit card loans, as lenders base their rates on the prime lending rate. The fed funds rate determines the premium rate that banks charge their best borrowers. Investors closely watch the Fed funds rate. Target rate fluctuations usually affect the stock market severely. A slight rate drop might cause the market to rise as corporations’ borrowing expenses fall. Many stock analysts watch FOMC remarks to predict the target rate.

What Is the Function of the Fed Funds Rate?

Banks charge each other the fed funds rate to borrow or lend excess reserves overnight. By law, banks must have a minimum reserve ratio relative to deposits. Federal Reserve Banks hold this reserve requirement. A bank with surplus reserve needs may lend cash overnight to other banks with reserve deficits.

What Determines the Fed Funds Rate?

The Federal Open Market Committee meets annually to set the fed funds rate. The core inflation rate and durable goods orders report affect these rates, indicating the country’s economic health.

How Are Federal Funds and Regular Interest Rates Different?

The Fed funds rate and interest rates are key U.S. financial indicators. The main difference is that the Fed funds rate establishes an overnight lending or borrowing range for banks. Stock markets are susceptible to rate fluctuations because they affect borrowing costs and financial conditions. The Fed funds rate indirectly affects short-term interest rates. However, Federal Reserve-set interest rates govern banks’ borrowing costs.

Final Remarks

The Fed uses the federal funds rate to oversee monetary policy, and investors follow it to predict market movement. The rate is a crucial U.S. financial indicator.


  • FOMC targets interest rates at the federal funds rate.
  • Commercial banks lend and borrow surplus reserves overnight at this rate.
  • The FOMC sets a target federal funds rate eight times a year, depending on economic factors.
  • Federal funds rates affect short-term consumer loan and credit card rates.
  • The federal funds rate affects the stock market, so investors watch it.


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