Legal Definitions - federal-funds rate

The federal-funds rate is the specific interest rate at which banks lend their excess reserve balances to other banks, typically on an overnight basis. Banks often engage in these short-term loans to ensure they meet their mandatory reserve requirements set by the Federal Reserve, or to manage their daily cash flow. The lending bank has surplus funds in its Federal Reserve account, while the borrowing bank temporarily needs additional funds. This rate is a critical benchmark in the financial system and is closely monitored and influenced by the Federal Reserve as a key tool for implementing monetary policy.

• Example 1: Managing Daily Reserve Requirements

  At the close of a business day, "Citywide Bank" finds itself with a surplus of funds in its reserve account at the Federal Reserve, exceeding its required minimum. Meanwhile, "Rural Credit Union" has experienced a higher-than-expected volume of withdrawals and is slightly short of its mandated reserve balance. To avoid penalties, Rural Credit Union will borrow the necessary funds from Citywide Bank for one night. The interest rate Citywide Bank charges Rural Credit Union for this specific overnight loan is the federal-funds rate, allowing both institutions to efficiently manage their liquidity and regulatory obligations.

• Example 2: Federal Reserve's Influence on Economic Activity

  Suppose the Federal Reserve decides that the economy needs a boost to encourage more spending and investment. It might announce a decision to lower its target range for the federal-funds rate. This action signals to all banks that it expects them to lend to each other at a lower interest rate. Consequently, it becomes cheaper for banks to borrow from one another, which can encourage them to lend more money to consumers and businesses at lower interest rates, thereby stimulating economic growth.

• Example 3: Impact on Broader Lending Rates

  A small business, "InnovateTech Solutions," needs a short-term loan to cover unexpected operational costs before a large client payment arrives next week. When InnovateTech approaches its bank for a line of credit, the interest rate it is offered will be indirectly influenced by the federal-funds rate. If the federal-funds rate is high, it means banks' cost of borrowing from each other is higher. This increased cost for the bank will likely translate into a higher interest rate for InnovateTech's business loan, demonstrating how the interbank lending rate ripples through the entire financial system and affects borrowing costs for individuals and businesses alike.