What is the Fed Funds Rate and Why is it Important?
The interest rate at which banks and credit unions lend money to each other, generally on an overnight basis. The law requires banks to keep a certain percentage of their customer’s money on reserve. Since banks do not earn interest on reserve money, institutions with surplus balances in their accounts lend those balances to institutions in need of larger balances.
The fed funds rate is one of the most important interest rates in the U.S. economy, as it directly affects critical aspects of the economy including employment, inflation and economic growth. The fed funds rate also indirectly influences short term interest rates because lenders often set their rates based on the prime lending rate. The prime lending rate is the rate at which banks charge their favored customers.
The federal funds target rate is determined by a meeting of the members of the Federal Open Market Committee (FOMC) which normally occurs eight times a year. The FOMC uses open market operations (buying and selling government securities) to influence the supply of money to meet the target rate.
For example, if the FOMC wants to increase the fed funds rate, they will decrease the money supply in the system which pushes interest rates higher. This is referred to as contractionary monetary policy.
On the contrary, when the economy is sluggish, and inflation is low, the FOMC will increase the money supply to lower the target rate. This is referred to as expansionist monetary policy.