The federal funds rate is the interest rate at which banks lend funds to each other from their deposits at the Federal Reserve (the Fed), usually overnight, in order to meet federally mandated reserve requirements. Basically, if a bank is unable to meet its reserve requirements at the end of the day, it borrows money from a bank with extra reserves. The federal funds rate is what banks charge each other for overnight loans. This rate is referred to as the federal funds effective rate and is negotiated between borrowing and lending banks.
The Federal Open Market Committee sets a target for the federal funds rate. The Fed does not directly control consumer savings or credit rates directly; it can’t require that banks use the federal funds rate for loans. Instead, the Fed lowers the federal funds rate by buying government-backed securities (usually U.S. Treasuries) from banks, which adds to the banks’ reserves. Having excess reserves, banks will lower their lending rates for overnight loans in order to make some interest on the excess reserves. To raise rates, the Fed sells securities to banks, decreasing the banks’ reserves. If enough banks need to borrow to meet overnight reserve requirements, banks with extra reserves will raise their lending rates.
The federal funds rate serves as a benchmark for many short-term rates, such as savings accounts, money market accounts, and short-term bonds. Banks also base the prime rate on the federal funds rate. Banks often use the prime rate as the basis for interest rates on deposits, bank loans, credit cards, and mortgages.
Prepared by Broadridge Investor Communication Solutions, Inc. Copyright 2018