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FEDERAL FUNDS:

A common term for Federal Reserve deposits held by commercial banks, especially when these deposits are loaned between banks through the Federal funds market. The interest rate charged for these interbank loans is termed the Federal funds rate. Federal funds are used by individual banks to meet reserve requirements and the total held by the banking system is manipulated by the Federal Reserve System in the conduct of monetary policy.
Federal funds are the deposits that commercial banks hold with the Federal Reserve System, that is, Federal Reserve deposits. These deposits are an important component of the reserves that banks keep to back up deposits (the other component is vault cash). The term Federal funds is commonly used when these deposits are loaned from one bank to another. The market used for these loans is then termed the Federal funds market and the interest rate one bank charges another for this lending is the Federal funds rate.

The lending of Federal funds is a common practice among modern commercial banks. Federal funds lending occurs because some banks have more reserves than needed to meet reserve requirements and some banks fall short. Banks in need of reserves borrow Federal funds from banks with extra reserves. The borrowing bank is able to satisfy reserve requirements and the lending bank generates a little extra interest revenue.

The FEDERAL part of FEDERAL funds is commonly misinterpreted to mean that commercial banks are somehow borrowing funds from the FEDERAL Reserve System itself. This is not the case. The word FEDERAL simply refers to the lending of FEDERAL Reserve deposits. The only role played by the Federal Reserve System is that of a record keeper, it merely manages the accounts. The Federal Reserve System is neither a lender nor a borrower of Federal funds.

Satisfying Reserve Requirements

Motivation for Federal funds lending arises from reserve requirements imposed on commercial banks by the Federal Reserve System (the Fed). Reserve requirements are rules imposed by the Fed to ensure that all bank depository institutions (traditional banks, savings and loan associations, credit unions, mutual savings banks, and even U.S. branches of foreign banks) keep enough reserves to back up customer deposits. The bank depository institutions have a two-week period to satisfy the requirements.

Due to the normal fluctuation of banking activity, some banks have more reserves than needed to satisfy requirements and some have fewer. On a given day, one bank might have a large number of withdrawals that temporarily reduce reserves while another bank has a large number of deposits that temporarily expand reserves. The temporary lending of reserves is a logical response to such imbalances among banks. Banks that borrow reserves are able to satisfy reserve requirements and banks that lend reserves generate extra revenue for their trouble. This is a win-win exchange for both sides.

Short and Long

Federal fund lending between banks come in two basic varieties. Most is short-term, during the course of a day or overnight. Some, however, is slightly longer, up to a couple of weeks.
  • Short Term: The bulk of Federal funds loans between banks is short term, a day or less. These loans are used by banks to make minor adjustments in reserves needed meet reserve requirements. The loans are typically unsecured, meaning the borrowing bank does not pledge collateral from other assets like U.S. Treasury securities. Moreover, the banks seldom enter into any sort of formal, written contract. One bank says "We need reserves." Another bank says, "Here you are, pay us back tomorrow." These loans are often between banks with an established relationship.

  • Long Term: In the world of Federal funds lending, long term is measured in weeks rather than days. Some banks find they need to borrow Federal funds for an extended period. Such extended loans come in two types. One is a fixed term, fixed interest rate loan. The specific length of time before repayment and the specific Federal funds rate charged are both fixed in advance, often in a written form. The other is a continuing, automatically renewed loan with an adjustable interest rate. This is basically an overnight loan that is automatically renewed, day after day, unless one side or the other decides to stop.

The Federal Funds Market

The Federal funds market is the organized mechanism used to facilitate the lending of Federal funds between banks. While traditional banks are the most noted participants in the Federal funds market, other entities with Federal Reserve deposits are also involved. The list includes traditional banks, savings and loan associations, credit unions, mutual savings banks, branches of foreign banks operating in the United States, federal agencies, and dealers who trade in government securities.

The first Federal funds loan between banks took place in 1921, less than a decade after the Federal Reserve System was created. The Federal funds market became quite active in the 1920s, but its use ebbed and flowed over the ensuing decades. It became increasingly active in the 1960s as it proceeded to assume its current position as a key component of the modern commercial banking system.

While the Federal funds market is extremely active, day in and day out, the market is somewhat informal. Written contracts are occasionally used, but most loans are only based on verbal agreements.

  • Bank to Bank: Most Federal funds lending is between banks with established working relationships. A short telephone call between banks is often enough to reach agreement on the terms of the loan. The lending bank then contacts the Federal Reserve System with instructions to transfer Federal Reserve deposits to the account of the borrowing bank. The process is quick, easy, and efficient.

  • Federal Funds Brokers: Some loans, however, are arranged by third party Federal funds brokers, who specialize in matching up banks in need of reserves with banks who have extra reserves to lend. The brokers, of course, charge a commission for their effort, but they expand the market, providing greater access of lenders to potential borrowers and borrowers to potential lenders. The borrowing bank need not have an established relationship with the lending bank.

The Federal Funds Rate

The interest rate charged for Federal funds lending is termed the Federal funds rate. This interest rate is one of the more important in the macroeconomy. It is watched by policy makers, business leaders, financial investors, astute consumers, and others with an interest in financial markets, banking, and the macroeconomy.

Contrary to popular misperception, the Federal funds rate is NOT set by the Federal Reserve System, but rather determined by the interaction among borrowers and lenders in the Federal funds market. The Fed can influence the Federal funds rate through monetary policy, but it does not actually set the rate.

The Federal funds rate is a key benchmark rate for the banking system. In one sense, it represents the basic cost of obtaining funds, funds that can then be used for consumer and business loans. As such, other bank interest rates are invariably linked to the Federal funds rate. Should the Federal funds rate increase, then interest rates on car loans, construction loans, mortgage loans, and others will also increase.

And Monetary Policy

Federal funds, the Federal funds market, and the Federal funds rate are critical to the conduct of modern monetary policy. The Federal Reserve System commonly targets the Federal funds rate when it sets a course of monetary policy. If the Fed seeks expansionary monetary policy, then it targets a lower Federal funds rate. If it pursues contractionary monetary policy, then it targets a higher Federal funds rate.

The connection between monetary policy and the Federal funds rate is so close than many people erroneously assume that the Fed is in direct control of the Federal funds rate. This is not true. The Fed does not directly control the Federal funds rate, but it can manipulate the rate by influencing the Federal funds market, which it accomplishes through open market operations.

If the Fed deems that a lower Federal funds rate is needed to stimulate the economy out of a recession, then it increases the total amount of Federal funds (Federal Reserve deposits) held by the banking system with the purchase of U.S. Treasury securities through open market operations. These additional reserves, similar to the supply increase in any market, motivates banks to loan Federal funds at a lower Federal funds rate.

Alternatively, if the Fed thinks a higher Federal funds rate is in order to restrain the economy and reduce inflationary pressures, then it decreases the total amount of Federal funds held by the banking system with the sale of U.S. Treasury securities through open market operations. This reduction of reserves, similar to the supply decrease in any market, motivates banks to loan Federal funds at a higher Federal funds rate.

<= FEDERAL DEPOSIT INSURANCE CORPORATIONFEDERAL FUNDS MARKET =>


Recommended Citation:

FEDERAL FUNDS, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2018. [Accessed: April 25, 2018].


Check Out These Related Terms...

     | Federal funds market | Federal funds rate | Federal Reserve System | reserve requirements | monetary policy | Federal Open Market Committee | Federal Reserve Banks | monetary economics | open market operations | discount rate | tight money | easy money | expansionary monetary policy | contractionary monetary policy | bank balance sheet |


Or For A Little Background...

     | Federal Reserve deposits | bank reserves | vault cash | fractional-reserve banking | banks | money | bank panic | check clearing | money creation | macroeconomics | monetary base | monetary aggregates | macroeconomic goals | market | financial markets |


And For Further Study...

     | central bank | Federal Reserve pyramid | Board of Governors, Federal Reserve System | Chairman of the Board of Governors, Federal Reserve System | Federal Deposit Insurance Corporation | Comptroller of the Currency | business cycles | unemployment | inflation | barter | aggregate market | gross domestic product | circular flow | goldsmith money creation |


Related Websites (Will Open in New Window)...

     | Federal Reserve System |


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