In the United States, the federal funds rate is the interest rate at which depository institutions (banks and credit unions) lend reserve balances to other depository institutions overnight on an uncollateralized basis. Reserve balances are amounts held at the Federal Reserve. Institutions with surplus balances in their accounts lend those balances to institutions in need of larger balances. The federal funds rate is an important benchmark in financial markets [1] [2] and central to the conduct of monetary policy in the United States as it influences a wide range of market interest rates. [3]
The effective federal funds rate (EFFR) is calculated as the effective median interest rate of overnight federal funds transactions during the previous business day. It is published daily by the Federal Reserve Bank of New York. [4]
The federal funds target range is determined by a meeting of the members of the Federal Open Market Committee (FOMC) which normally occurs eight times a year about seven weeks apart. The committee may also hold additional meetings and implement target rate changes outside of its normal schedule.
The Federal Reserve adjusts its administratively set interest rates, mainly the interest on reserve balances (IORB), to bring the effective rate into the target range. Additional tools at the Fed's disposal are: the overnight reverse repurchase agreement facility, discount rate, and open market operations. The target range is chosen to influence market interest rates generally and in turn ultimately the level of activity, employment and inflation in the U.S. economy. [3]
Financial institutions are obligated by law to hold liquid assets that can be used to cover sustained net cash outflows. [5] Among these assets are the deposits that the institutions maintain, directly or indirectly, with a Federal Reserve Bank. [6] An institution that is below its desired level of liquidity can address this temporarily by borrowing from institutions that have Federal Reserve deposits in excess of their requirement. The interest rate that a borrowing bank pays to a lending bank to borrow the funds is negotiated between the two banks, and the weighted average of this rate across all such transactions is the effective federal funds rate.
The Federal Open Market Committee regularly sets a target range for the federal funds rate according to its policy goals and the economic conditions of the United States. It directs the Federal Reserve Banks to influence the rate toward that range with adjustments to their own deposit interest rates. [7] Although this is commonly referred to as "setting interest rates," the effect is not immediate and depends on the banks' response to money market conditions.
Future contracts in the federal funds rate trade on the Chicago Board of Trade (CBOT), and the financial press refer to these contracts when estimating the probabilities of upcoming FOMC actions.
Interest on Reserve Balances (IORB) is the primary tool for achieving the target federal funds rate. It is an interest rate the Fed pays to banks for holding their funds at the Federal Reserve Bank. Because this offers a risk-free way to earn interest on their funds, banks do not tend to lend to each other at rates below the IORB, effectively setting a floor for the federal funds rate. [8]
Overnight Reverse Repurchase Agreement Facility is how the Fed sets rates for financial institutions which do not qualify to earn the IORB. It does this by allowing them to earn an interest on their funds via reverse repurchase agreements with the Fed. This helps further ensure a floor to the federal funds rate. [8]
Discount rate is the interest rate at which the Fed loans out its funds to eligible institutions via the discount window. This makes it unlikely for banks or other institutions to make loans at higher rates, therefore effectively setting a ceiling to the federal funds rate. [8]
Open Market Operations is when the Federal Reserve buys or sells government securities, thereby either adding or removing liquidity from the banking system. Without sufficient liquidity in the system, the other tools Fed uses become ineffective. [8]
Interbank borrowing is essentially a way for banks to quickly raise money. For example, a bank may want to finance a major industrial effort but may not have the time to wait for deposits or interest (on loan payments) to come in. In such cases the bank will quickly raise this amount from other banks at an interest rate equal to or higher than the Federal funds rate.
Raising the federal funds rate will dissuade banks from taking out such inter-bank loans, which in turn will make cash that much harder to procure. Conversely, dropping the interest rates will encourage banks to borrow money and therefore invest more freely. [9] This interest rate is used as a regulatory tool to control how freely the U.S. economy operates.
By setting a higher discount rate the Federal Reserve discourages banks from requisitioning funds from Federal Reserve Banks, yet positions itself as a lender of last resort.
Though the London Interbank Offered Rate (LIBOR), the Secured Overnight Financing Rate (SOFR) and the federal funds rate are concerned with the same action, i.e. interbank loans, they are distinct from one another, as follows:
Considering the wide impact a change in the federal funds rate can have on the value of the dollar and the amount of lending going to new economic activity, the Federal Reserve is closely watched by the market. The prices of Option contracts on fed funds futures (traded on the Chicago Board of Trade) can be used to infer the market's expectations of future Fed policy changes. Based on CME Group 30-Day Fed Fund futures prices, which have long been used to express the market's views on the likelihood of changes in U.S. monetary policy, the CME Group FedWatch tool allows market participants to view the probability of an upcoming Fed Rate hike. One set of such implied probabilities is published by the Cleveland Fed.
The last full cycle of rate increases occurred between June 2004 and June 2006 as rates steadily rose from 1.00% to 5.25%. The target rate remained at 5.25% for over a year, until the Federal Reserve began lowering rates in September 2007. The last cycle of easing monetary policy through the rate was conducted from September 2007 to December 2008 as the target rate fell from 5.25% to a range of 0.00–0.25%. Between December 2008 and December 2015 the target rate remained at 0.00–0.25%, the lowest rate in the Federal Reserve's history, as a reaction to the Financial crisis of 2007–2008 and its aftermath. According to Jack A. Ablin, chief investment officer at Harris Private Bank, one reason for this unprecedented move of having a range, rather than a specific rate, was because a rate of 0% could have had problematic implications for money market funds, whose fees could then outpace yields. [12] In October 2019 the target range for the Federal Funds Rate was 1.50–1.75%. [13] On March 15, 2020, the target range for Federal Funds Rate was 0.00–0.25%, [14] a full percentage point drop less than two weeks after being lowered to 1.00–1.25%. [15]
In light of the 2021–2022 global inflation surge, the Federal Reserve has raised the FFR aggressively. In the latter half of 2022, the FOMC had hiked the FFR by 0.75 percentage points on 4 different consecutive occasions, and in its final meeting of 2022, hiked the FFR a further 0.5 percentage points. The FFR sat around 4.4% in 2022, and at the time the Fed foreshadowed that the rate would not be lowered until 2024 at the earliest. [16] [17]
In Sept. 2024, the Fed lowered its benchmark rate for the first time since 2020 by 50 basis points. [18]
When the FOMC wishes to reduce interest rates they will increase the supply of money by buying government securities. When additional supply is added and everything else remains constant, the price of borrowed funds – the federal funds rate – falls. Conversely, when the Committee wishes to increase the federal funds rate, they will instruct the Desk Manager to sell government securities, thereby taking the money they earn on the proceeds of those sales out of circulation and reducing the money supply. When supply is taken away and everything else remains constant, the interest rate will normally rise. [19]
The Federal Reserve has responded to a potential slow-down by lowering the target federal funds rate during recessions and other periods of lower growth. In fact, the committee's lowering has recently predated recessions, [20] in order to stimulate the economy and cushion the fall. Reducing the federal funds rate makes money cheaper, allowing an influx of credit into the economy through all types of loans.
The charts referenced below show the relation between S&P 500 and interest rates.
Bill Gross of PIMCO suggested that in the prior 15 years ending in 2007, in each instance where the fed funds rate was higher than the nominal GDP growth rate, assets such as stocks and housing fell. [30]
A low federal funds rate makes investments in developing countries such as China or Mexico more attractive. A high federal funds rate makes investments outside the United States less attractive. The long period of a very low federal funds rate from 2009 forward resulted in an increase in investment in developing countries. As the United States began to return to a higher rate in the end of 2015 investments in the United States became more attractive and the rate of investment in developing countries began to fall. The rate also affects the value of currency, a higher rate slowing the decrease of the U.S. dollar and decreasing the value of currencies such as the Mexican peso. [60]
The Federal Reserve System is the central banking system of the United States. It was created on December 23, 1913, with the enactment of the Federal Reserve Act, after a series of financial panics led to the desire for central control of the monetary system in order to alleviate financial crises. Over the years, events such as the Great Depression in the 1930s and the Great Recession during the 2000s have led to the expansion of the roles and responsibilities of the Federal Reserve System.
The monetary policy of the United States is the set of policies which the Federal Reserve follows to achieve its twin objectives of high employment and stable inflation.
The Federal Open Market Committee (FOMC) is a committee within the Federal Reserve System that is charged under United States law with overseeing the nation's open market operations. This Federal Reserve committee makes key decisions about interest rates and the growth of the United States money supply. Under the terms of the original Federal Reserve Act, each of the Federal Reserve banks was authorized to buy and sell in the open market bonds and short term obligations of the United States Government, bank acceptances, cable transfers, and bills of exchange. Hence, the reserve banks were at times bidding against each other in the open market. In 1922, an informal committee was established to execute purchases and sales. The Banking Act of 1933 formed an official FOMC.
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The discount window is an instrument of monetary policy that allows eligible institutions to borrow money from the central bank, usually on a short-term basis, to meet temporary shortages of liquidity caused by internal or external disruptions.
Excess reserves are bank reserves held by a bank in excess of a reserve requirement for it set by a central bank.
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Bank rate, also known as discount rate in American English, and (familiarly) the base rate in British English, is the rate of interest which a central bank charges on its loans and advances to a commercial bank. The bank rate is known by a number of different terms depending on the country, and has changed over time in some countries as the mechanisms used to manage the rate have changed.
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The System Open Market Account (SOMA) is a securities portfolio managed by the Federal Reserve Bank of New York, that holds the assets it has purchased through open market operations (OMOs) in the course of carrying out monetary policy. Through SOMA transactions, the Federal Reserve System influences interest rates and the amount of reserves in the US banking system. Income from SOMA assets also provides funding for the Federal Reserve's activities, which are not funded by Congress. The Federal Open Market Committee (FOMC) instructs the Reserve Bank of New York as to how it should use the SOMA to support monetary policy.
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