Federal funds rate
Encyclopedia
In the United States
, the federal funds rate is the interest rate
at which depository institution
s actively trade balances held at the Federal Reserve, called federal funds
, with each other, usually overnight, on an uncollateralized
basis. 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 market
s.
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.
The Federal Reserve uses open market operations to influence the supply of money
in the U.S. economy
to make the federal funds effective rate follow the federal funds target rate. The target value is known as the neutral federal funds rate. At this rate, growth rate of real GDP
is stable in relation to Long Run Aggregate Supply at the expected inflation rate.
s and thrift institution
s are obligated by law to maintain certain levels of reserves, either as reserves
with the Fed or as vault cash. The level of these reserves is determined by the outstanding assets and liabilities of each depository institution, as well as by the Fed itself, but is typically 10% of the total value of the bank's demand account
s (depending on bank size). In the range of $9.3 million to $43.9 million, for transaction deposit
s (checking accounts, NOW
s, and other deposits that can be used to make payments) the reserve requirement in 2007-2008 was 3 percent of the end-of-the-day daily average amount held over a two-week period. Transaction deposits over $43.9 million held at the same depository institution carried a 10 percent reserve requirement.
For example, assume a particular U.S. depository institution, in the normal course of business, issues a loan. This dispenses money and decreases the ratio of bank reserves to money loaned. If its reserve ratio drops below the legally required minimum, it must add to its reserves to remain compliant with Federal Reserve regulations. The bank can borrow the requisite funds from another bank that has a surplus in its account with the Fed. 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 nominal rate is a target set by the governors of the Federal Reserve, which they enforce primarily by open market operations. That nominal rate is almost always what is meant by the media referring to the Federal Reserve "changing interest rates." The actual Fed funds rate generally lies within a range of that target rate, as the Federal Reserve cannot set an exact value through open market operations.
Another way banks can borrow funds to keep up their required reserves is by taking a loan from the Federal Reserve itself at the discount window
. These loans are subject to audit by the Fed, and the discount rate
is usually higher than the federal funds rate. Confusion between these two kinds of loans often leads to confusion between the federal funds rate and the discount rate. Another difference is that while the Fed cannot set an exact federal funds rate, it can set a specific discount rate.
The federal funds rate target is decided by the governors at Federal Open Market Committee
(FOMC) meetings. The FOMC members will either increase, decrease, or leave the rate unchanged depending on the meeting's agenda and the economic conditions of the U.S. It is possible to infer the market expectations of the FOMC decisions at future meetings from the Chicago Board of Trade
(CBOT) Fed Funds futures contract
s, and these probabilities are widely reported in the financial media.
. For example, a bank may want to finance a major industrial effort but 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. Thus this interest rate acts as a regulatory tool to control how freely the US economy operates.
By setting a higher discount rate the Federal Bank discourages banks from requisitioning funds from the Federal Bank, yet positions itself as a lender of last resort
.
(LIBOR) and the federal funds rate are concerned with the same action, i.e. interbank loans, they are distinct from one another, as follows:
) can be used to infer the market's expectations of future Fed policy changes. One set of such implied probabilities is published by the Cleveland Fed.
cut from 1.0% to a range of zero to 0.25%. 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. This followed the 50 basis point cut on October 29, 2008, and the unusually large 75 basis point cut made during a special January 22, 2008 meeting, as well as a 50 basis point cut on January 30, 2008, a 75 basis point cut on March 18, 2008, and a 50 basis point cut on October 8, 2008.
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, price normally falls. The price here is the interest rate (cost of money) and specifically refers to the Federal Funds Rate. Conversely, when the Committee wishes to increase the Fed 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, price (or in this case interest rates) will normally rise.
The Federal Reserve has responded to a potential slow-down by lowering the target federal funds rate during recession
s and other periods of lower growth. In fact, the Committee's lowering has recently predated recessions, in order to stimulate the economy and cushion the fall. Reducing the Fed Funds Rate makes money cheaper, allowing an influx of credit in to the economy through all types of loans.
The charts linked below show the relation between S&P 500
and interest rates.
Bill Gross
of PIMCO has suggested that in the past 15 years, every time the fed funds rate was higher than the nominal GDP
growth rate, assets such as stocks and/or housing always fell. He even suggested that the best way to price the fed funds rate would be 100 basis points, or 1 % below the nominal GDP growth rate.
United States
The United States of America is a federal constitutional republic comprising fifty states and a federal district...
, the federal funds rate is the interest rate
Interest rate
An interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender. For example, a small company borrows capital from a bank to buy new assets for their business, and in return the lender receives interest at a predetermined interest rate for...
at which depository institution
Depository institution
A depository institution is a financial institution in the United States that is legally allowed to accept monetary deposits from consumers...
s actively trade balances held at the Federal Reserve, called federal funds
Federal funds
In the United States, federal funds are overnight borrowings by banks to maintain their bank reserves at the Federal Reserve. Banks keep reserves at Federal Reserve Banks to meet their reserve requirements and to clear financial transactions...
, with each other, usually overnight, on an uncollateralized
Collateral (finance)
In lending agreements, collateral is a borrower's pledge of specific property to a lender, to secure repayment of a loan.The collateral serves as protection for a lender against a borrower's default - that is, any borrower failing to pay the principal and interest under the terms of a loan obligation...
basis. 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 market
Financial market
In economics, a financial market is a mechanism that allows people and entities to buy and sell financial securities , commodities , and other fungible items of value at low transaction costs and at prices that reflect supply and demand.Both general markets and...
s.
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
Federal Open Market Committee
The Federal Open Market Committee , a committee within the Federal Reserve System, is charged under United States law with overseeing the nation's open market operations . It is the Federal Reserve committee that makes key decisions about interest rates and the growth of the United States money...
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 uses open market operations to influence the supply of money
Money supply
In economics, the money supply or money stock, is the total amount of money available in an economy at a specific time. There are several ways to define "money," but standard measures usually include currency in circulation and demand deposits .Money supply data are recorded and published, usually...
in the U.S. economy
Economy of the United States
The economy of the United States is the world's largest national economy. Its nominal GDP was estimated to be nearly $14.5 trillion in 2010, approximately a quarter of nominal global GDP. The European Union has a larger collective economy, but is not a single nation...
to make the federal funds effective rate follow the federal funds target rate. The target value is known as the neutral federal funds rate. At this rate, growth rate of real GDP
Gross domestic product
Gross domestic product refers to the market value of all final goods and services produced within a country in a given period. GDP per capita is often considered an indicator of a country's standard of living....
is stable in relation to Long Run Aggregate Supply at the expected inflation rate.
Mechanism
U.S. bankBank
A bank is a financial institution that serves as a financial intermediary. The term "bank" may refer to one of several related types of entities:...
s and thrift institution
Savings and loan association
A savings and loan association , also known as a thrift, is a financial institution that specializes in accepting savings deposits and making mortgage and other loans...
s are obligated by law to maintain certain levels of reserves, either as reserves
Reserve requirement
The reserve requirement is a central bank regulation that sets the minimum reserves each commercial bank must hold of customer deposits and notes...
with the Fed or as vault cash. The level of these reserves is determined by the outstanding assets and liabilities of each depository institution, as well as by the Fed itself, but is typically 10% of the total value of the bank's demand account
Demand account
A transactional account is a deposit account held at a bank or other financial institution, for the purpose of securely and quickly providing frequent access to funds on demand, through a variety of different channels....
s (depending on bank size). In the range of $9.3 million to $43.9 million, for transaction deposit
Transaction deposit
In the United States, transactions deposit is a term used by the Federal Reserve for checkable deposits and other accounts that can be used directly as cash without withdrawal limits or restrictions. They are the only bank deposits that require the bank to keep reserves at the central bank...
s (checking accounts, NOW
Negotiable Order of Withdrawal account
In the United States, a Negotiable Order of Withdrawal account is a deposit account that pays interest, on which checks may be written....
s, and other deposits that can be used to make payments) the reserve requirement in 2007-2008 was 3 percent of the end-of-the-day daily average amount held over a two-week period. Transaction deposits over $43.9 million held at the same depository institution carried a 10 percent reserve requirement.
For example, assume a particular U.S. depository institution, in the normal course of business, issues a loan. This dispenses money and decreases the ratio of bank reserves to money loaned. If its reserve ratio drops below the legally required minimum, it must add to its reserves to remain compliant with Federal Reserve regulations. The bank can borrow the requisite funds from another bank that has a surplus in its account with the Fed. 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 nominal rate is a target set by the governors of the Federal Reserve, which they enforce primarily by open market operations. That nominal rate is almost always what is meant by the media referring to the Federal Reserve "changing interest rates." The actual Fed funds rate generally lies within a range of that target rate, as the Federal Reserve cannot set an exact value through open market operations.
Another way banks can borrow funds to keep up their required reserves is by taking a loan from the Federal Reserve itself at the discount window
Discount window
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...
. These loans are subject to audit by the Fed, and the discount rate
Discount rate
The discount rate can mean*an interest rate a central bank charges depository institutions that borrow reserves from it, for example for the use of the Federal Reserve's discount window....
is usually higher than the federal funds rate. Confusion between these two kinds of loans often leads to confusion between the federal funds rate and the discount rate. Another difference is that while the Fed cannot set an exact federal funds rate, it can set a specific discount rate.
The federal funds rate target is decided by the governors at Federal Open Market Committee
Federal Open Market Committee
The Federal Open Market Committee , a committee within the Federal Reserve System, is charged under United States law with overseeing the nation's open market operations . It is the Federal Reserve committee that makes key decisions about interest rates and the growth of the United States money...
(FOMC) meetings. The FOMC members will either increase, decrease, or leave the rate unchanged depending on the meeting's agenda and the economic conditions of the U.S. It is possible to infer the market expectations of the FOMC decisions at future meetings from the Chicago Board of Trade
Chicago Board of Trade
The Chicago Board of Trade , established in 1848, is the world's oldest futures and options exchange. More than 50 different options and futures contracts are traded by over 3,600 CBOT members through open outcry and eTrading. Volumes at the exchange in 2003 were a record breaking 454 million...
(CBOT) Fed Funds futures contract
Futures contract
In finance, a futures contract is a standardized contract between two parties to exchange a specified asset of standardized quantity and quality for a price agreed today with delivery occurring at a specified future date, the delivery date. The contracts are traded on a futures exchange...
s, and these probabilities are widely reported in the financial media.
Applications
Interbank borrowing is essentially a way for banks to quickly raise capitalCapital (economics)
In economics, capital, capital goods, or real capital refers to already-produced durable goods used in production of goods or services. The capital goods are not significantly consumed, though they may depreciate in the production process...
. For example, a bank may want to finance a major industrial effort but 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. Thus this interest rate acts as a regulatory tool to control how freely the US economy operates.
By setting a higher discount rate the Federal Bank discourages banks from requisitioning funds from the Federal Bank, yet positions itself as a lender of last resort
Lender of last resort
A lender of last resort is an institution willing to extend credit when no one else will. The term refers especially to a reserve financial institution, most often the central bank of a country, intended to avoid bankruptcy of banks or other institutions deemed systemically important or 'too big to...
.
Comparison with LIBOR
Though the London Interbank Offered RateLondon Interbank Offered Rate
The LIBOR rate is the average interest rate that leading banks in London charge when lending to other banks. It is an acronym for London Interbank Offered Rate Banks borrow money for one day, one month, two months, six months, one year etc. and they pay interest to their lenders based on...
(LIBOR) and the federal funds rate are concerned with the same action, i.e. interbank loans, they are distinct from one another, as follows:
- The target federal funds rate is a target interest rate that is set by the FOMC for implementing U.S. monetary policies.
- The (effective) federal funds rate is achieved through open market operations at the Domestic Trading Desk at the Federal Reserve Bank of New York which deals primarily in domestic securities (U.S. Treasury and federal agencies' securities).
- LIBOR is calculated from prevailing interest rates between highly credit-worthy institutions.
- LIBOR may or may not be used to derive business terms. It is not fixed beforehand and is not meant to have macroeconomic ramifications.
Predictions by the market
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 TradeChicago Board of Trade
The Chicago Board of Trade , established in 1848, is the world's oldest futures and options exchange. More than 50 different options and futures contracts are traded by over 3,600 CBOT members through open outcry and eTrading. Volumes at the exchange in 2003 were a record breaking 454 million...
) can be used to infer the market's expectations of future Fed policy changes. One set of such implied probabilities is published by the Cleveland Fed.
Historical rates
As of December 16, 2008, the most recent change the FOMC has made to the funds target rate is a 75 to 100 basis pointBasis point
A basis point is a unit equal to 1/100 of a percentage point or one part per ten thousand...
cut from 1.0% to a range of zero to 0.25%. 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. This followed the 50 basis point cut on October 29, 2008, and the unusually large 75 basis point cut made during a special January 22, 2008 meeting, as well as a 50 basis point cut on January 30, 2008, a 75 basis point cut on March 18, 2008, and a 50 basis point cut on October 8, 2008.
Explanation of federal funds rate decisions
When the Federal Open Market CommitteeFederal Open Market Committee
The Federal Open Market Committee , a committee within the Federal Reserve System, is charged under United States law with overseeing the nation's open market operations . It is the Federal Reserve committee that makes key decisions about interest rates and the growth of the United States money...
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, price normally falls. The price here is the interest rate (cost of money) and specifically refers to the Federal Funds Rate. Conversely, when the Committee wishes to increase the Fed 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
Money supply
In economics, the money supply or money stock, is the total amount of money available in an economy at a specific time. There are several ways to define "money," but standard measures usually include currency in circulation and demand deposits .Money supply data are recorded and published, usually...
. When supply is taken away and everything else remains constant, price (or in this case interest rates) will normally rise.
The Federal Reserve has responded to a potential slow-down by lowering the target federal funds rate during recession
Recession
In economics, a recession is a business cycle contraction, a general slowdown in economic activity. During recessions, many macroeconomic indicators vary in a similar way...
s and other periods of lower growth. In fact, the Committee's lowering has recently predated recessions, in order to stimulate the economy and cushion the fall. Reducing the Fed Funds Rate makes money cheaper, allowing an influx of credit in to the economy through all types of loans.
The charts linked below show the relation between S&P 500
S&P 500
The S&P 500 is a free-float capitalization-weighted index published since 1957 of the prices of 500 large-cap common stocks actively traded in the United States. The stocks included in the S&P 500 are those of large publicly held companies that trade on either of the two largest American stock...
and interest rates.
- July 13, 1990 — Sept 4, 1992: 8.00%–3.00% (Includes 1990–1991 recession) rate drop chart rate rise chart
- Feb 1, 1995 — Nov 17, 1998: 6.00–4.75 rate drop chart1 rate drop chart2 rate rise chart
- May 16, 2000 — June 25, 2003: 6.50–1.00 (Includes 2001 recession) rate drop chart1 rate drop chart2 rate rise chart
- June 29, 2006 — (Oct. 29 2008): 5.25–1.00 rate drop chart
- Dec 16, 2008: 0.0–0.25
Bill Gross
Bill Gross
Bill Gross is an American businessman. Born in 1958, he grew up in Encino, California. He founded GNP Loudspeakers , an audio equipment manufacturer; GNP Development Inc., acquired by Lotus Software; and Knowledge Adventure, an educational software company, later acquired by Cendant...
of PIMCO has suggested that in the past 15 years, every time the fed funds rate was higher than the nominal GDP
Gross domestic product
Gross domestic product refers to the market value of all final goods and services produced within a country in a given period. GDP per capita is often considered an indicator of a country's standard of living....
growth rate, assets such as stocks and/or housing always fell. He even suggested that the best way to price the fed funds rate would be 100 basis points, or 1 % below the nominal GDP growth rate.
See also
- EoniaEoniaEonia is an effective overnight interest rate computed as a weighted average of all overnight unsecured lending transactions in the interbank market. It has been initiated within the euro area by the contributing panel banks.It is one of the two benchmarks for the money and capital markets in the...
- Euro Interbank Offered Rate
- Federal funds probability
- Federal Reserve Economic DataFederal Reserve Economic DataFRED is a database of more than 39,000 economic time series managed by the Federal Reserve Bank of St. Louis. The data can be viewed in graphical and text form or downloaded for import to a database or spreadsheet...
- Monetary policyMonetary policyMonetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability. The official goals usually include relatively stable prices and low unemployment...
- SARONSARONSARON is an overnight interest rates average referencing the Swiss Franc interbank repo market. It was launched by the Swiss National Bank in cooperation with SIX Swiss Exchange. Since 25 August 2009, SARON has replaced the previously used repo overnight index...
- SONIASONIASONIA is the acronym for Sterling OverNight Index Average, the reference rate for overnight unsecured transactions in the Sterling market...
- Taylor ruleTaylor ruleIn economics, a Taylor rule is a monetary-policy rule that stipulates how much the central bank should change the nominal interest rate in response to changes in inflation, output, or other economic conditions. In particular, the rule stipulates that for each one-percent increase in inflation, the...
- Zero interest rate policyZero interest rate policyThe zero interest rate policy is a macroeconomic concept describing conditions with a very low interest rate, such as contemporary Japan and, since December 16, 2008, the United States. It can be associated with slow economic growth....
External links
- Historical Data: Effective Federal Funds Rate (interactive graph) from the Federal Reserve Bank of St. Louis
- Federal Reserve Web Site: Federal Funds Rate Historical Data (including the current rate), Monetary Policy, and Open Market Operations
- MoneyCafe.com page with Fed Funds Rate and historical chart and graph
- Historical chart
- Historical data (since 1954) comparing the US GDP growth rate versus the US Fed Funds Rate - in the form of a chart/graph
- Federal Reserve Bank of Cleveland: Fed Fund Rate Predictions
- Federal Funds Rate Data including Daily effective overnight rate and Target rate
- http://www.ny.frb.org/markets/omo/dmm/fedfundsdata.cfm
- http://www.ny.frb.org/markets/statistics/dlyrates/fedrate.html