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Federal Funds Rate: Definition & History

Instructor: Dr. Douglas Hawks

Douglas has two master's degrees (MPA & MBA) and is currently working on his PhD in Higher Education Administration.

The Federal Funds Rate is one of a few important rates that banks use. In this lesson, you'll learn what the federal funds rate is and what it means to you.

Definition

The Federal Funds Rate is the target interest rate, set by the Federal Reserve Bank, that depository banks in the United States charge when they extend overnight loans to each other. That's the definition; now, let's make sense of it.

Reserve Requirements and Overnight Loans

Retail banks or depository banks in the United States must comply with a number of regulations, some of which are set forth by the Federal Reserve Bank ('the Fed'). One of the requirements the Fed sets for banks is known as the reserve requirement, or the percentage of their total deposits that they are required to keep on hand. The reserve requirement is typically 10%, meaning that if we owned a bank that held $100 million in deposits from customers, we must have $10 million in cash on hand.

Think of an average bank and how much cash goes in and out of a branch each day. Now multiply that by the thousands of branches some of the large US banks operate. Keeping track of how much they have in deposits is fairly simple with their computer systems. But with all that cash coming in and going out of the bank all day long, the total deposits change daily, meaning the necessary cash on hand also changes.

To create a quick and efficient market where banks that need extra funds overnight to meet the reserve requirement, can borrow large sums, and a market where banks with more cash than they need can lend money, the Fed allows banks to lend to and borrow from each other. These loans only last overnight - ten hours at most. But they are still loans and they still have an interest rate.

Setting the Federal Funds Rate

Part of the Fed, the Federal Open Market Committee (FOMC), participates in the market by selling and buying government securities. Because the Fed is such a big market player, when they buy these bonds, interest rates go down, and when they sell the bonds, interest rates go up. They do this on a daily basis to control the Federal Funds Rate.

When you hear a news report stating 'the Fed has kept the Federal Funds Rate at 0%,' it can be a little misleading. The Fed doesn't set a rate simply by saying, 'the rate is 0%;' they announce a target rate - the rate they want to see the Federal Funds Rate at, and then they buy or sell bonds to move the rate as necessary. For the last three years, the Federal Funds Rate has been at 0%, but what that really means is that the FOMC keeps the rate between 0% and .25%.

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