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What is it the federal funds rate? The federal funds rate is the overnight lending interest rate banks charge one another to borrow money. You may be wondering, why

What is it the federal funds rate?

The federal funds rate is the overnight lending interest rate banks charge one another to borrow money.

You may be wondering, why do banks need to borrow money from each other?

First, let’s look at how banks bring in money. They take in deposits and use a certain percentage of deposits to provide loans to consumers.

Before the 2008 financial crisis and the Great Recession, banks often kept their reserves holdings low. Actually, they sometimes even fell below the minimum required by the Federal Reserve. And when that happened, they had to borrow money overnight from other banks. The market for all of this borrowing and lending between banks is called the federal funds market and its interest rate is known as the federal funds rate.

The federal funds rate provides a tool through which the Fed can affect the economy through open market operations.

Want to dig deeper on monetary policy and the Fed’s role in the economy? Check out our Macroeconomics section on Monetary Policy and the Federal Reserve.

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What is the federal funds rate? The federal funds rate is the overnight lending interest rate banks charge one another to borrow money. Yes, banks do loan money to each other. Why is that? Well, recall that banks make money by taking in deposits and using those deposits to make loans. Banks cannot lend out all of their deposits because they need some funds on hand to settle transactions with other banks, to give to customers, and also to satisfy the Federal Reserve, which requires by law that banks hold a certain percentage of their deposits as reserves.

 

Prior to 2008, the banks didn't have much incentive to keep excess reserves, reserves above and beyond what was required by law. So the banks tried to keep reserve holdings relatively low. Sometimes, they even fell too low to meet Fed requirements so they borrowed reserves from other banks. Borrowing and lending in the federal funds market established an interest rate or the federal funds rate. The federal funds rate is important because the Fed tries to affect the federal funds rate by conducting something called open market operations, and through this tool, affects credit conditions and the rest of the economy.

 

However, it's important to keep in mind that while the Fed has considerable control over the federal funds rate, there are lots of different interest rates. In theory, these interest rates move together, and they're affected by the interest rate the Fed does influence. In practice, those connections can be looser or tighter, and that will dictate how good a job or how exact a job the Fed does in steering the economy.

 

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