Legal Definitions - fed-funds rate

The federal funds rate (often shortened to fed-funds rate) is a target interest rate set by the Federal Reserve, the central bank of the United States. It represents the rate at which commercial banks lend their excess reserves to other banks on an overnight basis. Banks engage in these overnight loans to meet their reserve requirements or to manage their daily cash flow efficiently. While the Federal Reserve doesn't directly set this rate, it influences it through various monetary policy tools, primarily open market operations. This rate is crucial because it serves as a benchmark that influences many other interest rates throughout the economy, including those for mortgages, car loans, and credit cards, thereby impacting borrowing costs for businesses and consumers.

• Example 1: Managing Daily Bank Reserves

  Imagine "Citywide Bank" ends the business day with slightly less cash in its reserve account at the Federal Reserve than regulations require. To avoid penalties, it needs to borrow funds quickly. Meanwhile, "Regional Trust," another commercial bank, has a surplus of reserves. Citywide Bank can borrow the necessary funds from Regional Trust for one night. The interest rate they agree upon for this overnight loan will be very close to the federal funds rate target set by the Federal Reserve.

  This example illustrates how banks use the fed-funds market to manage their daily reserve levels, with the federal funds rate guiding the cost of such short-term, overnight borrowing between financial institutions.

• Example 2: The Federal Reserve's Response to Inflation

  Suppose the Federal Reserve observes that inflation is rising rapidly, indicating that the economy might be growing too quickly. To cool things down, the Federal Reserve decides to increase its target for the federal funds rate. This action signals to banks that they should charge each other more for overnight loans. Consequently, other interest rates, like those for consumer loans and business credit, also tend to rise, making borrowing more expensive. This discourages spending and investment, which helps to curb inflationary pressures.

  This demonstrates how the federal funds rate is a primary tool for the Federal Reserve to implement monetary policy, influencing broader economic conditions by making borrowing more or less attractive across the economy.

• Example 3: Impact on Consumer Lending Rates

  Maria is planning to buy a new car and is comparing different auto loan offers. She notices that the interest rates for car loans have recently increased across several lenders. This change often follows an increase in the federal funds rate target by the Federal Reserve. Lenders, facing higher borrowing costs themselves (or anticipating them), pass these increased costs on to consumers in the form of higher interest rates for auto loans, mortgages, and other forms of credit.

  This example shows the ripple effect of the federal funds rate, illustrating how changes in this interbank rate ultimately influence the cost of borrowing for everyday consumers, such as those seeking a car loan.