Federal Funds Rate Mechanics

The federal funds rate is the interest rate at which commercial banks lend reserves to each other for a single day. It is not set by a single transaction or a market price in the traditional sense. Instead, the Federal Reserve announces a target rate and then uses open-market operations to keep the actual rate close to that target. Understanding how the Fed nudges a market with thousands of players to hit its target is essential to understanding modern monetary policy.

Why banks borrow reserves overnight

Every night, banks must settle their accounts. They are required to hold a minimum amount of reserves at the Federal Reserve — currently 0% for most deposits (the requirement was eliminated in March 2020). If a bank ends the day with fewer reserves than it needs, it must borrow from another bank that has excess reserves. The borrowing happens in a market called the federal funds market, and the rate on these loans is the federal funds rate. The loans are very short-term — just overnight — because both banks will adjust their positions the next day.

The Federal Reserve does not directly set the federal funds rate the way a store sets a price for milk. Instead, it sets a target range for the rate and then uses open-market operations to influence supply and demand for reserves so the actual rate trades within the target.

How the Fed influences the rate: reserve supply and demand

The federal funds rate, like any price, depends on supply and demand. The supply is the total reserves in the banking system. The demand is the amount of reserves banks want to hold. If the Fed wants the rate to be lower, it increases the supply of reserves — by buying securities from banks. Banks get cash, which increases total reserves in the system. With more reserves available, banks are willing to lend overnight reserves at a lower rate because they have excess.

Conversely, if the Fed wants the rate to be higher, it decreases the supply of reserves — by selling securities to banks or allowing previously purchased securities to mature without reinvestment. Banks now have fewer reserves to lend, so the federal funds rate rises.

The Discount Rate and the interest on reserves floor and ceiling

The Federal Reserve sets a “corridor” around the target federal funds rate using two tools:

The Discount Rate (the discount rate): Banks can always borrow directly from the Fed at this rate. So the federal funds rate should never go much higher than the discount rate — if it did, banks would just borrow from the Fed instead of from each other. The discount rate acts as a ceiling.

Interest on Excess Reserves (IOR): Banks that hold reserves at the Fed earn interest, paid by the Fed. If the IOR is too high, banks want to hold excess reserves at the Fed rather than lend them to other banks at the federal funds rate. So the federal funds rate should not fall much below IOR. The IOR acts as a floor.

By setting IOR just below the target rate and the discount rate just above it, the Fed creates a narrow corridor. The actual federal funds rate is likely to trade within that corridor automatically.

The implementation challenge: reserve balances are not always scarce

For decades, this system worked well. Banks needed reserves to meet requirements, so reserves were relatively scarce. When the Fed wanted to raise the federal funds rate, it simply drained reserves (by selling securities), and the rate rose. When it wanted to lower the rate, it added reserves.

But after 2008 and especially after 2020, the Fed created so many reserves through quantitative easing and emergency lending that reserves became abundant. Banks had far more reserves than they needed. In this environment, the traditional supply-and-demand logic broke down. If there is a huge oversupply of reserves, banks will lend overnight reserves at nearly zero no matter what. The Fed’s target is irrelevant if the supply is excessive.

The reverse repo facility: managing the floor during abundant reserves

To solve this problem, the Fed created a facility called the “reverse repo” market, where banks and other financial institutions can deposit cash at the Fed and receive securities (Treasuries) in return. The reverse repo rate acts as a floor — if no one is offering a high enough rate for overnight lending, banks will just put excess cash into the reverse repo and earn the reverse repo rate. By paying interest on reverse repos, the Fed ensures the federal funds rate does not fall too far below its target.

The mechanics on a typical day

On a typical day, the Federal Reserve starts by estimating how many reserves the banking system will have at the end of the day. If the estimate is that reserves will be above the level the Fed wants, the Fed will sell securities in the morning (through its trading desk at the New York Fed). Banks buy these securities with cash, which flows back to the Fed and reduces reserves in the system. This tightens conditions and puts upward pressure on the federal funds rate.

If the estimate is that reserves will be below target, the Fed buys securities, adding reserves to the system and putting downward pressure on the federal funds rate. Throughout the day, the Fed watches what the actual federal funds rate is and may intervene further if it is drifting away from target.

The policy signal: what the Fed signals by moving the target

When the Federal Reserve raises its target federal funds rate, it is saying monetary policy is becoming more restrictive — borrowing will be more expensive, and the Fed wants to slow the economy and cool inflation. When it lowers the target, it is signaling accommodation — cheaper borrowing, a desire to stimulate growth. Markets react strongly to Fed announcements of target changes because the federal funds rate touches every other interest rate in the economy.