federal funds rate

Federal Funds Rate

The federal funds rate is the interest rate at which banks lend money to each other overnight. When a bank needs to meet its short-term cash requirements, it can typically borrow funds from another bank that has a surplus. The rate they charge each other for this borrowing is the federal funds rate.

This rate is set by the Federal Open Market Committee (FOMC), a group within the Federal Reserve System that meets roughly eight times per year. The FOMC does not directly mandate the rate, but it sets a target range and uses monetary policy tools to keep the rate within that range. When inflation rises, the Fed generally raises the target rate to cool borrowing and spending. When the economy slows down, it typically lowers the rate to encourage borrowing and growth.

Why It Matters

Even though the federal funds rate applies to lending between banks, it has a broad effect on everyday consumers. Banks generally pass the cost of borrowing on to their customers, which means changes in the federal funds rate typically ripple through to mortgage rates, auto loan rates, credit card interest rates, and savings account yields. In most cases, when the federal funds rate goes up, borrowing becomes more expensive for consumers. When it goes down, borrowing tends to become cheaper.

For savers, a higher federal funds rate can be a positive development, since banks often offer better yields on savings accounts and certificates of deposit (CDs) during periods of higher rates.

Example

Suppose the Federal Reserve raises its target federal funds rate from 4.5% to 5.0%. A bank that was previously offering a 30-year fixed mortgage at 6.8% might adjust its rates upward to around 7.2% or higher within the following weeks. A consumer who was planning to buy a home may now face a higher monthly payment for the same loan amount. At the same time, that consumer’s high-yield savings account may begin offering a slightly better annual percentage yield (APY) as banks compete for deposits.

Related Terms

• Prime rate: The interest rate banks typically charge their most creditworthy customers, often tied directly to the federal funds rate.
• Discount rate: The rate at which the Federal Reserve lends money directly to commercial banks.
• Annual percentage rate (APR): The yearly cost of borrowing money, expressed as a percentage, including fees and interest.
• Monetary policy: The actions taken by the Federal Reserve to manage inflation and support economic growth, including adjusting interest rates.
• Inflation: The general rise in prices over time, which the Federal Reserve often tries to control by adjusting the federal funds rate.