The federal funds rate explained
The federal funds rate (or fed funds rate) is the interest rate at which commercial banks lend reserve balances to each other overnight. On the surface, it seems obscure—a behind-the-scenes rate between banks, not a public rate like mortgages or car loans. But it is the most important interest rate in the economy. All other rates anchor to it. When the Fed raises the fed funds rate, mortgage rates, auto-loan rates, and credit-card APRs climb. When the Fed lowers it, borrowing costs fall across the board. This article explains what the fed funds rate is, how the Fed sets it, why it matters so much, and how it transmits to the real economy.
Quick definition: The federal funds rate is the interest rate banks charge each other on overnight loans of reserve balances held at the Federal Reserve. The Fed targets this rate as its primary tool to steer monetary policy.
Key takeaways
- The fed funds rate is the overnight rate banks use to lend reserves to each other, not a rate the Fed directly controls
- The Fed sets a target range for this rate (e.g., 5.25%–5.50%) and uses open-market operations to keep the actual rate near the target
- Changes in the fed funds rate ripple through the economy: banks adjust prime lending rates, which affect mortgages, auto loans, credit cards, and adjustable-rate products
- The fed funds rate is the anchor for all other interest rates; when it rises or falls, most rates move in the same direction
- The Fed doesn't physically set the rate; it influences it by adjusting the supply of reserves banks hold overnight
What are reserve balances?
To understand the fed funds rate, you need to know what reserves are. Commercial banks are required to hold a reserve balance at the Federal Reserve—a fraction of the deposits they take from customers. These reserves are the "bank money" at the Fed itself.
For example, if a bank takes $100 million in deposits, the Fed may require it to hold $10 million in reserves (a 10% reserve requirement, though the requirement has been lowered significantly in recent years). The bank lends out the remaining $90 million. If the bank needs more reserves than required during the day—say, to cover unexpected outflows—it borrows from another bank's excess reserves, and they agree on an overnight interest rate.
This is the fed funds rate: the rate one bank pays to borrow another's overnight reserves.
Why the overnight market matters
Banks manage reserve balances to stay above the legal minimum. If a bank falls short at the day's end, it must borrow from a bank with surplus reserves. This overnight lending market is crucial because:
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Constant settlement: Every day, billions of dollars in payments flow through the banking system. Banks end the day with different reserve balances depending on which deposits left and which arrived. The overnight market lets them rebalance without holding expensive excess reserves.
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Real funding costs: The rate banks pay to borrow reserves reflects the true cost of funds. If the fed funds rate is 5%, a bank must pay 5% annually to borrow $1 million overnight. This feeds into the bank's lending decisions. If the bank's cost of funds is 5%, it won't lend to customers at 4%; it must charge more than its cost.
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Transmission mechanism: The fed funds rate is the entry point for monetary policy. When the Fed changes this rate, it affects every other rate in the system.
How the Fed sets the fed funds rate
Here's the surprising part: the Fed doesn't directly set the fed funds rate. The rate is determined by supply and demand in the overnight market, just like any other price. But the Fed targets a range and uses tools to keep the actual rate near that range.
As of 2024, the Fed targets a range: say, 5.25%–5.50%. The actual overnight fed funds rate varies slightly day to day, but it stays within this range on average.
The Fed influences the fed funds rate in three main ways:
1. Open-Market Operations (OMOs)
The Fed buys and sells government securities. When the Fed wants to lower the fed funds rate (stimulate the economy), it buys bonds, injecting money (reserves) into the banking system. Banks have more reserves available and are willing to lend them to each other at lower rates. When the Fed wants to raise the fed funds rate (fight inflation), it sells bonds, sucking money (reserves) out of the system. Banks have fewer reserves and charge higher rates to lend them.
Example: In March 2020, during the pandemic, the Fed began buying bonds massively. The federal funds rate, targeted at 0.00%–0.25%, fell to near zero. In March 2022, to fight inflation, the Fed began selling bonds and allowing its balance sheet to shrink. The fed funds rate rose to 5.25%–5.50% by mid-2023.
2. Discount rate (Fed's lending rate)
The Fed offers a "discount window" where banks can borrow directly from the Fed at the discount rate. If a bank needs reserves urgently and the overnight market rate is too high, it can borrow from the Fed at the discount rate. The Fed sets this rate above the fed funds target to discourage banks from relying on it. But the discount rate acts as a ceiling: banks won't pay more than the discount rate to borrow reserves overnight, so the fed funds rate stays below it.
If the Fed raises the discount rate, the fed funds rate tends to rise (banks are willing to pay more to avoid Fed borrowing). If the Fed lowers the discount rate, the fed funds rate tends to fall.
3. Interest paid on reserve balances (IORB)
The Fed pays interest on the reserves banks hold at the Fed. The rate is called interest on reserve balances (IORB). If the Fed raises the IORB, banks are incentivized to hold more reserves (they earn interest) and lend fewer reserves to each other, pushing the fed funds rate up. If the Fed lowers the IORB, banks are less eager to hold reserves and more willing to lend them out, pushing the fed funds rate down.
Example: In 2008, during the financial crisis, the Fed cut the fed funds rate to zero but also began paying interest on reserves (IORB), keeping banks willing to hold cash even at near-zero rates. This was crucial because at zero rates with no IORB, banks might have loaned out all their reserves, destabilizing the overnight market.
How the fed funds rate affects other rates
The fed funds rate is the anchor, but not every rate moves in lockstep. Here's the transmission:
Prime rate: Banks' primary lending rate (for their best customers) is set 3 percentage points above the fed funds rate. If the fed funds rate is 5.25%, the prime rate is 8.25%. Banks base other rates off prime: mortgages might be prime + 1%, auto loans prime + 2%, credit cards prime + 10%.
Mortgages: Adjustable-rate mortgages (ARMs) and refinancing rates move immediately with fed funds changes. Fixed-rate mortgages are more complex—they're priced off the 10-year Treasury yield, which depends on market expectations of future fed funds rates. If the Fed raises rates and is expected to keep them high, the 10-year yield rises, pushing mortgage rates up even more than the immediate fed funds increase.
Credit cards: Most credit-card APRs are linked directly to prime, which is fed funds + 3%. If the Fed raises fed funds by 1 percentage point, credit-card rates rise by 1 percentage point too, within a month.
Savings accounts: Banks pass through fed funds changes slowly to savings rates. When the Fed cuts rates, banks cut savings rates quickly (profits are preserved). When the Fed raises rates, banks raise savings rates slowly (profits are squeezed). This asymmetry is why Fed rate increases help borrowers more than savers.
Business lending: Banks adjust business loan rates to prime plus a spread. Large corporations can negotiate lower spreads; small businesses pay higher spreads. A rise in fed funds immediately raises business borrowing costs.
Here's a stylized example:
Fed funds rate rises from 1% to 2% (100 basis points).
Prime rate rises from 4% to 5%.
30-year fixed mortgage rate rises from 3.5% to ~4.5% (if market expectations shift).
Credit card APR rises from 19% to 20%.
Small business loan rate rises from 8% to 9%.
The lag effect
The fed funds rate doesn't affect the real economy instantly. There's a transmission lag of 6–18 months before a rate change ripples into spending, hiring, and inflation.
Months 0–1: The Fed announces a rate change; banks adjust lending rates.
Months 1–3: Households and businesses notice higher borrowing costs. Some delay purchases (mortgages), but most decisions take time. A homebuyer might wait to see if rates decline.
Months 3–6: Spending begins to slow. Fewer mortgages are issued; business investment plans are postponed. Hiring growth slows.
Months 6–12: The slowdown spreads. GDP growth tapers; unemployment begins to rise.
Months 12–18: Inflation finally moderates as demand cools. Wage growth, which depends partly on labor-market tightness, eventually decelerates.
This lag is why the Fed must act on forecasts, not current data. If the Fed waits until inflation is visibly high to raise rates, the lag means inflation will peak even higher before falling. The Fed must tighten when inflation is rising but not yet peaked. Conversely, the Fed must cut rates before a recession is obvious, based on growth forecasts.
Why the fed funds rate is important
The fed funds rate is the lynchpin of monetary policy for several reasons:
1. Universal spillover. Because the prime rate and other rates move with fed funds, every borrower is affected. The Fed doesn't have to reach out to each bank individually; the overnight market transmits the Fed's influence to mortgage-seekers, small-business owners, and credit-card holders.
2. Central bank credibility. The fed funds rate is the visible signal of the Fed's commitment. If the Fed raises the rate and keeps it raised, markets see the Fed is serious about inflation. If the Fed cuts rates quickly, markets see the Fed is worried about recession. The rate is the Fed's megaphone.
3. Expectation anchor. Markets use the current and expected fed funds rate to form expectations about future inflation and growth. If the Fed commits to holding rates at 2% for two years, markets price long-term bonds based on that expectation. If the Fed is seen as unreliable, markets demand a risk premium, raising all long-term rates.
4. Global impact. The U.S. dollar is the world's reserve currency, and U.S. interest rates anchor global finance. When the Fed raises the fed funds rate, money flows into dollar-denominated assets (Treasury bonds, U.S. banks), strengthening the dollar and affecting emerging markets' borrowing costs. The Fed's policy radiates globally.
Real-world example: The 2022–2023 rate cycle
In December 2021, with inflation rising and unemployment at 3.9%, the Fed signaled that rate increases were coming. The Fed funds rate was at 0%–0.25%.
In March 2022, amid 7% inflation, the Fed raised the fed funds rate to 0.25%–0.50% and began selling bonds. This was the first rate hike in three years. Markets were shocked—the Fed had been dovish (easy) for so long.
Over the next 12 months, the Fed raised the fed funds rate seven more times, reaching 5.25%–5.50% by July 2023. This was the fastest tightening cycle in decades.
The transmission was swift:
- April 2022: Prime rate rose to 5.50%; mortgage rates jumped from 3.0% to 5.0%.
- May 2022: Credit-card APRs hit 20%, up from 16% a year earlier.
- August 2022: Business lending slowed; small-business loan approvals declined.
- October 2022: GDP fell in Q3; recession signals flashed.
- December 2022: Unemployment began rising from 3.4% to 4.0% by October 2023.
- June 2023: Inflation moderated to 3.0%, down from 9.1% a year earlier.
The lag showed clearly: the Fed raised rates in March 2022, but unemployment didn't rise meaningfully until late 2022. Inflation didn't peak and decline until mid-2023—a 12–15 month lag.
Common mistakes about the fed funds rate
Mistake 1: Confusing the fed funds rate with the prime rate. The fed funds rate is the overnight bank-to-bank rate; the prime rate is set by banks at fed funds + 3% and is used for consumer lending. They're related but not identical.
Mistake 2: Thinking the Fed directly sets the fed funds rate. The Fed targets a range and uses three tools (OMOs, discount rate, IORB) to keep the actual overnight rate near the target. The market ultimately sets the rate; the Fed influences it.
Mistake 3: Assuming all rates move proportionally. A 1% increase in the fed funds rate might increase prime lending by 1%, mortgages by 0.8%, and credit cards by 1.0%, depending on the term and type of loan. Long-term rates (mortgages, bonds) are less sensitive to fed funds changes than short-term rates (auto loans, credit cards).
Mistake 4: Forgetting the lag effect. Changes in the fed funds rate take 6–18 months to affect inflation and employment. Observers who judge the Fed's success week-to-week are looking at the wrong window.
Mistake 5: Overlooking market expectations. The fed funds rate is important, but so is the market's expectation of future fed funds rates. If the Fed raises rates to 5% but markets expect rates to fall to 2% within two years, long-term borrowing costs might stay low. Expectations, not just current rates, drive the economy.
FAQ
Why is the fed funds rate between banks, not a consumer rate?
Consumers don't borrow from the Fed directly. The fed funds rate is the wholesale cost of funds between banks. Banks use this rate to calculate their lending rates to consumers. By controlling the wholesale rate, the Fed influences all the retail rates without having to negotiate directly with millions of consumers.
Can I borrow at the fed funds rate?
No. The fed funds rate is available only to banks borrowing from each other overnight. Consumers can't access it. However, some adjustable-rate products (home equity lines, adjustable mortgages) are indirectly tied to it through the prime rate.
How does the Fed know if the fed funds rate is at its target?
The Fed monitors actual overnight trading activity and calculates a daily average fed funds rate. If the average falls below the target range, it means the market rate is too low, so the Fed injects more reserves to keep it up. If it's above the target, the Fed withdraws reserves to push it down. The Fed adjusts multiple times a day if needed.
What if banks don't want to lend reserves?
During financial crises, banks hoard reserves for safety, and the overnight market freezes. In 2008, the fed funds rate spiked because banks wouldn't lend. The Fed responded by paying interest on reserves (IORB) and expanding its lending programs so banks could borrow directly. This restored market functioning.
Is the fed funds rate the same everywhere?
The fed funds rate varies microscopically day to day and minute to minute within the trading day, but it's essentially uniform across all overnight trades on any given day. The Fed publishes a "Effective Federal Funds Rate," which is the volume-weighted average of all overnight trades.
Related concepts
- What is monetary policy?
- Discount rate vs fed funds rate
- The Federal Reserve's dual mandate
- Inflation: a deep dive
- Interest rates and bonds
Summary
The federal funds rate is the overnight interest rate banks charge each other on reserve balances. Although it's a bank-to-bank rate, it's the Fed's primary tool for steering monetary policy, and it anchors all other consumer and business lending rates. The Fed targets a range for this rate and uses open-market operations, the discount rate, and interest on reserves to keep the actual rate near its target. Changes in the fed funds rate ripple through the economy with a lag of 6–18 months, affecting mortgages, auto loans, credit cards, and business lending. Understanding the fed funds rate is essential for interpreting Fed announcements and predicting how interest rate changes will affect borrowing costs and the broader economy.