Legal Definitions - fed funds

Fed funds is a common shorthand for the Federal Funds Rate. This is a critical interest rate in the United States economy, set as a target by the Federal Open Market Committee (FOMC) of the Federal Reserve. It represents the interest rate at which commercial banks lend their excess reserves to other banks on an overnight basis. While the Federal Reserve sets a target, the actual rate can fluctuate slightly based on the market's supply and demand for these reserves. This rate significantly influences other interest rates throughout the economy, affecting everything from mortgage rates to business loans and savings account yields.

Here are some examples to illustrate the concept of the federal funds rate:

• Impact on Consumer Lending: Imagine the Federal Reserve decides to raise the federal funds rate target. This action makes it more expensive for banks to borrow money from each other overnight. To compensate for their increased borrowing costs, banks will typically pass these higher costs on to their customers. Consequently, you might see interest rates on new credit card offers, car loans, and adjustable-rate mortgages begin to climb. A family planning to buy a new car might find that the interest rate offered by their bank for an auto loan is higher than it was a few months prior, directly reflecting the Fed's decision to increase the fed funds rate.

• Bank Liquidity Management: Consider a situation where a large commercial bank, at the end of a business day, finds itself with slightly fewer reserves than required by regulatory standards. To avoid penalties, this bank needs to quickly borrow reserves from another bank that has an excess. The interest rate that the borrowing bank pays for this overnight loan of reserves will be very close to the prevailing federal funds rate. This illustrates how the fed funds rate directly governs the cost of short-term, interbank lending, allowing banks to manage their daily liquidity needs efficiently.

• Investor Expectations and Market Reactions: Suppose financial news outlets report that the Federal Reserve is widely expected to lower the federal funds rate at its upcoming meeting. Investors might anticipate that lower interest rates will stimulate economic activity, making it cheaper for businesses to borrow money for expansion and investment. This expectation could lead to a surge in stock market prices as investors buy shares, believing that corporate profits will improve in a more robust economic environment. Conversely, the yields on government bonds might fall, as new bonds are issued at lower rates, reflecting the overall cheaper cost of borrowing influenced by the fed funds rate.