Contrary to popular misperception, the Federal funds rate is NOT set by the Federal Reserve System (the Fed), 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.

Federal Funds

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.

The Federal Funds Market

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.

A Key Rate

• First and foremost, it is a benchmark interest rates commonly used to determine other interest rates. Other interest rates that are usually pegged to the Federal funds rate include interest rates that banks pay on deposits (savings deposits, certificates of deposits, individual retirement accounts, Eurodollars, repurchase agreements, etc.) and interest rates that banks charge for loans (car loans, construction loans, mortgage loans, development loans, real estate loans, small business loans, etc.).


• Second and also important, the Federal funds rate is a key indicator of economic activity. As a benchmark for other interest rates, policy makers, business leaders, financial investors, astute consumers, and others with an interest in financial markets, banking, and the macroeconomy keep a close on the Federal funds rate. The Federal Reserve System regularly targets the Federal funds rate when pursuing monetary policy--a lower rate to reduce unemployment and a higher rate to control inflation.


• Third and well worth emphasizing, the Federal funds rate is an important component of the costs of acquiring funds. Banks obtain the funds they use for loans from a variety of sources. The most important source, of course, is customer deposits. Another seldom used source is discount borrowing from the Federal Reserve System. A key source, however, is the Federal funds market, making the Federal funds rate something of a baseline cost that banks can expect to pay for acquiring funds.

And Monetary Policy

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 does 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.