Definition / Meaning of Federal funds rate
The federal funds rate is the interest rate at which depository institutions (such as banks and credit unions) lend reserve balances to each other overnight. This rate is a key benchmark in the U.S. financial system and is the primary tool used by the Federal Reserve System (the Fed) to conduct monetary policy. It is not a rate that the Fed sets directly; rather, the Fed sets a target range for the federal funds rate and uses open market operations to influence the rate to stay within that range.
How the Federal Funds Rate Works
Banks are required by regulation to hold a certain amount of reserves (cash or deposits at the Fed) based on their customer deposits. If a bank finds itself short of reserves at the end of the day, it can borrow from another bank that has excess reserves. The interest rate on these overnight loans between banks is the federal funds rate. The supply and demand for these reserves determine the actual rate. The Fed influences this rate through its open market operations (buying and selling government securities) and by setting the interest it pays on banks’ reserve balances (the interest on reserve balances (IORB) rate).
The Federal Open Market Committee (FOMC)
The Federal Open Market Committee (FOMC) meets eight times a year to assess economic conditions and decide on the appropriate target range for the federal funds rate. The FOMC’s decisions are guided by its dual mandate: to promote maximum employment and to maintain stable prices (keeping inflation around 2%).
Why the Federal Funds Rate Matters
Changes to the federal funds rate have a powerful ripple effect throughout the economy. Because it influences borrowing costs for banks, it affects the interest rates that consumers and businesses face on loans, mortgages, savings accounts, and credit cards.
- Higher federal funds rate: The Fed raises the target to cool down the economy and fight inflation. This makes borrowing more expensive (e.g., higher mortgage rates, higher car loan rates), encourages saving (higher savings account yields), and slows down spending and investment.
- Lower federal funds rate: The Fed lowers the target to stimulate the economy during a slowdown or recession. This makes borrowing cheaper, discourages saving, and encourages spending and investment, which helps boost economic activity.
Impact on Key Financial Measures
| Measure | Typical Effect of a Fed Rate Hike | Typical Effect of a Fed Rate Cut |
|---|---|---|
| Prime Rate | Increases | Decreases |
| Mortgage Rates | Increase (especially adjustable-rate) | Decrease |
| Savings & CD Yields | Increase | Decrease |
| Stock Market | Often falls (higher borrowing costs) | Often rises (cheaper money) |
| U.S. Dollar Value | Tends to strengthen | Tends to weaken |
Federal Funds Rate vs. the Discount Rate
It is important not to confuse the federal funds rate with the discount rate. The discount rate is the interest rate the Fed charges banks when they borrow directly from the Fed’s discount window. The discount rate is typically set higher than the federal funds rate to encourage banks to borrow from each other first.
Recent Context
In recent years, the federal funds rate has seen dramatic changes. During the COVID-19 pandemic in 2020, the Fed slashed the rate to near zero (0.00% to 0.25%) to support the economy. Then, starting in 2022, as inflation surged to 40-year highs, the Fed aggressively raised the rate to a range of 5.25% to 5.50% by mid-2023, the highest level in over two decades. As of 2025, the Fed may begin cutting the rate again as inflation moderates and the labor market shows signs of cooling.
In summary, the federal funds rate is the most important interest rate in the U.S. economy. It is the Fed’s main lever for controlling inflation, managing employment, and steering the overall health of the economy. Every move in the federal funds rate sends a signal to financial markets and directly impacts the wallets of everyday consumers.