What Is the Federal Funds Rate?

What Is the Federal Funds Rate?

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  • August 26, 2022
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The federal funds rate, or fed funds rate, is the interest rate that U.S. banks charge each other for uncollateralized, overnight loans. As these short-term loans are a foundational part of banking activity, small changes in the fed funds rate can create big impacts on financial and economic activity.

When you hear about an interest rate increase or decrease in the news, it’s often because the U.S. Federal Reserve has increased or decreased its target for the fed funds rate.

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As the central bank of the United States, the Federal Reserve influences the federal funds rate as part of its broader efforts to influence monetary policy and economic activity.

For starters, it’s important to understand that regulated depository institutions must keep an approved amount of cash as “reserves” to protect the financial system. This can be idle “vault cash,” but also electronic funds held directly by the Fed in reserve accounts.

Technically, the Federal Reserve doesn’t have the authority to mandate a fixed interest rate to the rest of the financial system. However, it can easily influence the broader interest rate environment by making it harder or easier for banks to meet their reserve requirements.

If it wants to make things easier, it can offer to buy more U.S. Treasury bonds back from banks – thus giving them the capital they need free from interbank loans. If it wants rates to rise based on its current federal funds target, it will stop purchasing as many Treasurys and force banks to depend on loans to each other (and the associated overnight interest rates) to meet these reserve requirements.

The effective federal funds rate is the actual rate at which depository institutions are lending to each other, which differs from the “target” federal funds rate publicized by the Federal Reserve.

Sometimes the effective fund rate differs slightly from the target rate based on day-to-day specifics, and other times it diverges because banks are either anticipating a big change or responding to extreme market conditions.

It’s also worth noting that in the wake of the 2008 financial crisis, the Fed set its “target” rate as a range between zero and 0.25% and the effective rate was intended to float somewhere in that range. By way of example, in August 2010, the effective fed funds rate was about 0.19% thanks to global uncertainty that caused real lending rates to sit at the top of that range. By August 2013, they had fallen to just 0.08%, at the lower end of that range.

On an average day, hundreds of billions of dollars change hands in interbank loans – commonly because institutions need more capital to meet their regulatory requirements. So just a few basis points on these loans can cause significant behavior changes.

Think of it this way: If a bank is regularly getting charged 1% on overnight loans just to meet its regulatory requirements, it has to charge at least 1% on every loan to businesses or consumers if it wants to break even. And if it wants to invest in the future or generate significant profits for shareholders, it will probably have to charge much more than that.

Again, the Fed can’t even mandate a fixed fed funds rate, let alone require mortgage lenders or credit card companies to offer a specific figure. It just sets a target, and only for overnight loans between banks. But the changes in that target move the rates on almost every other loan in the economy, both large and small.

The central bank’s congressional mandate is twofold: to support maximum employment and to support price stability. The Federal Reserve has several tools at its disposal to influence monetary policy in the service of these goals, and changes to the federal funds rate is one of the more important ones.

That’s because changes in interest rates change the cost and frequency of lending. Lower rates make it easier for businesses and consumers to buy big-ticket items on credit, while higher rates cause those purchases to be more difficult.

It may sound counterintuitive for the Federal Reserve to ever want people to buy less. But as we’ve seen in 2022 with record rates of inflation driven in part by pent-up pandemic demand, slowing down the rate of spending is sometimes in the best interest of long-term economic stability. At its core, that’s why the Fed has recently raised rates.

The recent round of rate increases in 2022 is perhaps the most notable series of changes in the fed funds rate in more than a decade. The Fed’s July decision to raise its fed funds target to 2.25% to 2.50% marked the fourth increase already in 2022. What’s more, based on the public statements from the central bank and predictions by Wall Street, there are expectations that the fed funds rate could top 3.25% by late 2022 – a huge change from the fed funds rate target of near zero from 2008 through 2015.

This kind of brisk and sustained increase in rates is not unprecedented, however. Nor is a rate of about 3% particularly high from a historical perspective. Consider that across 13 months in 1994 and 1995, the Federal Reserve raised rates seven times amid fears of an overheating economy sparking inflation. Specifically, the federal funds rate almost doubled, from 3.05% to 6.05%.

There are also older examples that are even more extreme, including unprecedented moves by the Federal Reserve in the 1970s that briefly sent the fed funds rate as high as 20%. That’s higher than some less creditworthy consumers get charged for their credit cards. However, just as the global economy was much different before smartphones and email, it’s worth noting that monetary policy and economics were very different disciplines some 50 years ago.

Perhaps unsurprisingly, the boom-and-bust nature of the U.S. economy means a similar ebb and flow in interest rates as the Fed responds to current market conditions.

In 2007, before the financial crisis, the fed funds rate was 5.25% before it was slashed to nearly zero in a bid to prop up the nation in the wake of the Great Recession.

Before that, in the wake of the 2000 dot-com crisis, interest rates were cut from 5.75% to 1.25% in roughly two years.

Not all interest rate cuts are in response to a dramatic economic crisis, however. The Federal Reserve cut rates from more than 9% in 1989 to a brief low of less than 3% in 1993, as part of Chairman Alan Greenspan’s “Great Moderation” that featured steady growth, falling unemployment and tempered inflation amid a period of generally low economic volatility.

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