Federal Funds Rate

Ever since the recent economic downturn in the United States and the rest of the world, more attention has been paid to the one institution that is crucial to the entire banking and financial system of the U.S. and to the global economy: the central bank of the United States, known as the Federal Reserve (or simply “the Fed”). The Fed is in control of the American money supply and in charge of setting important monetary policy that indirectly influences the lives of every consumer in every market.

One of the most important tools that the Fed has at its disposal in terms of monetary policy is the ability to set the so-called Federal funds rate, which is the interest rate at which a private financial institution lends money to another financial instituation through the Federal Reserve System. Within the Fed, the Federal Open Market Committee is tasked with determining the current Federal funds rate. Although the public often thinks, when hearing of the Fed “changing interest rates” in the news, that the rate the Fed sets is the actual rate at which all such bank-to-bank lending transactions take place, this is not the case. The Federal Reserve only sets the nominal rate, which it then tries enforcing through its open market operations, but the effective interest rates of individual transactions are negotiated by the private banks themselves between each other.

The Federal nominal funds rate is nevertheless very important as it is an indicator for banks and encourages particular financial behaviors. A high Federal funds rate discourages banks from raising capital through interbank loans, and thus may slow down the general lending market, whereas lowering the nominal interest rate will do the opposite, giving an incentive to banks to borrow more freely from each other and make bolder investments.