Us Federal Funds Rate

In the United States, the federal funds rate is the interest rate at which private depository institutions lend balances at the Federal Reserve to other depository institutions, on a short-term basis. In other words, it is the interest rate banks charge each other for loans.

The interest rate that the borrowing bank pays to the 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 federal funds effective rate.

The federal funds target rate is determined by a meeting of the members of the Federal Open Market Committee 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.

Interbank borrowing is essentially a way for banks to quickly raise capital. For example, a bank may want to finance a major industrial effort but not have the time to wait for deposits or interest 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. Thus this interest rate acts as a regulatory tool to control how freely the US economy operates.

A higher fed funds rate means banks are less willing to borrow money to keep their reserves at the mandated level. This means they will lend less money out, and that the money they do lend will be at a higher rate since they themselves are borrowing money at a higher rate. Since loans are more difficult to get and more expensive, businesses will be less likely to borrow, thus slowing the economy. When the Fed raises rates, it is called contractionary monetary policy.

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