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What Is Meant By Fed Funds Rate? How Does It Work? Explain In Detail

Referencing Styles : Chicago | Pages : 1

Fed Funds Rate:

Federal Funds Rate is termed as the rate of interest the lending bank can charge to other banks for lending them money from their reserve balances on an overnight basis. By law the bank must maintain a reserve that will be equal to a certain percentage of their deposits in an account at a Federal Reserve Bank. Any money in their reserve that exceeds the desired level is available for lending the money to other bank that might have the shortfall. The Federal Reserve uses the fed funds rate as a tool to control the U.S. economic growth. This makes it the most important interest rate in the world. The most important of the Federal Fund Rate is the London Interbank Offering Rate that is commonly known as the Libor. It is defined as the rate that the banks charge on each other for one month or three month or six month and even for one year loan. Banks also base the prime rate on the fed funds rate. Banks can charge their best prime rate to the customers and that is how the fed funds rate can also affect the other rates of interest. These rates of interest include the interest rate on deposits, bank loans, adjustable rate mortgages and credit cards. The long term rates of interests are indirectly influenced. The investors want a higher rate of interest in terms of long term Treasury note. The yields on Treasury notes drive the long term conventional mortgage interest rates.

How the Federal Funds Rate Works:

It is important for banks and other depository institutions that they should maintain a non-interest bearing accounts at the Federal Reserve banks while ensuring that they have enough money to cover depositors’ withdrawals and other obligations. The amount of money that must be kept in account is known as a reserve requirement and is based on the percentage of total deposit by the bank. The balance at the end of the day averaged over two week reserve maintenance period is used to determine the required need to meet the reserve requirements. If a bank expects to have a end of the day balance that would be greater than what is required it can lend the excess amount to an institution that can anticipate the shortfall in its balance. Hence the interest rate that can be charged by the lending bank is termed as federal fund rate or fed funds rate. The Federal Open Market Committee or the FOMC is a type of monetary policy that makes the policy making body of the entire Federal Reserve System. It is held eight times a year in order to set the Federal Funds Rate. The FOMC is responsible for making decisions about the rate of adjustments based on the key indicators of economy while showing signs of inflation, recession or other issues. The indicators include measures including the core inflation rate and the report for durable goods. The FOMC cannot force other banks to charge the exact rate. Rather the FOMC can set up a rate of target. The actual rate of interest rate that is lent to a bank is determined through negotiation between two banks. The weighted average of interest rates across all transactions of this type is known as the effective federal funds rate. While the FMOC is unable to mandate a particular federal fund rate, the Federal Reserve System can adjust the supply of money so that the rate of interest can move towards the target rate. By increasing the amount of money in the system it can cause the rate of interest to fall while decreasing the money supply and increasing the rate of interest. The target of the federal funds has varied in a wide range over the years creating response to the prevailing condition of economy. It was set as high as 20% in the early 1980s in response to the inflation. With the coming of the Great Recession in the year 2007 till 2009, the rate was slashed to a record low target of 0% to 0.25% in an attempt to encourage the growth. A committee of the Federal Reserve is responsible for setting up target of federal funds rate based on the prevailing condition of economy. The rate of federal funds can influence short term rates on consumer loans and credit cards. Investors can also pay attention to the federal fund rates as a result of rise or fall in in the rates that can sway the stock market. As of June 19 in the year 2019, the rate of fed funds is about 2.5 percent. The Federal Open Market Committee raised the fed fund rate by four times in 2018, there times in 2017 and now it is expecting to keep it up by 2.5 percent through 2021. The FMOC changes the fed fund rates in order to control the inflation while maintaining the healthy economic growth. The member of the FOMC makes use of the economic indicators for signs of inflation or recession. The key indicator of inflation is the core inflation rate. The critical indicator for recession is the durable report of the goods. In addition to it, The FOMC can take about 12 to 18 months to change the fed fund rate to affect the entire economy. The stock market investors watch the monthly FOMC meetings very minutely. About one fourth of the fed fund rates stimulates the economic growth and sends out the markets higher in jubilation. About one fourth point gets increased in the fed fund rate leading to curb inflation. The Federal Reserve has many other tools in addition to the fed fund rates. It is a type of discount rate that keeps the federal fund rate at the top. It is how the Fed charges the banks while borrowing from it directly through the discount window. It creates a program so as to fight the financial crisis. The Fed makes uses of tools to control the overall supply of money within the nation.

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