Federal Funds Rate compared toU.S. Treasuryinterest rates

Inflation (blue) compared to federal funds rate (red)

Quarterly gross domestic product compared to Federal Funds Rate.

Federal Funds Rate and Treasury interest rates from 2002-2019

In theUnited States, thefederal funds rateis theinterest rateat whichdepository institutions(banks and credit unions) lend reserve balances to other depository institutions overnight, on anuncollateralizedbasis.Reserve balancesare amounts held at theFederal Reserveto maintain depository institutionsreserve requirements. Institutions with surplus balances in their accounts lend those balances to institutions in need of larger balances. The federal funds rate is an important benchmark infinancial markets.12

The interest rate that the borrowing bank pays to the lending bank to borrow the funds is negotiated between the two banks, and the weighted average of this rate across all such transactions is thefederal funds effective rate.

Thefederal funds target rateis determined by a meeting of the members of theFederal Open Market Committeewhich normally occurs eight times a year about seven weeks apart. The committee may also hold additional meetings and implement target rate changes outside of its normal schedule.

The Federal Reserve usesopen market operationsto make the federal funds effective rate follow the federal funds target rate. The target rate is chosen in part to influence themoney supplyin theU.S. economy3

Financial institutions are obligated by law to maintain certain levels of reserves, either asreserveswith the Fed or as vault cash. The level of these reserves is determined by the outstanding assets and liabilities of each depository institution, as well as by the Fed itself, but is typically 10%4of the total value of the banksdemand accounts(depending on bank size). In the range of $9.3 million to $43.9 million, fortransaction depositschecking accountsNOWs, and other deposits that can be used to make payments) the reserve requirement in 20072008 was 3 percent of the end-of-the-day daily average amount held over a two-week period. Transaction deposits over $43.9 million held at the same depository institution carried a 10 percent reserve requirement.

For example, assume a particular U.S. depository institution, in the normal course of business, issues a loan. This dispenses money and decreases the ratio of bank reserves to money loaned. If its reserve ratio drops below the legally required minimum, it must add to its reserves to remain compliant with Federal Reserve regulations. The bank can borrow the requisite funds from another bank that has a surplus in its account with the Fed. The interest rate that the borrowing bank pays to the lending bank to borrow the funds is negotiated between the two banks, and the weighted average of this rate across all such transactions is the federal fundseffectiverate.

Thefederal funds target rateis set by the governors of the Federal Reserve, which they enforce byopen market operationsand adjustments in the interest rate on reserves.5The target rate is almost always what is meant by the media referring to the Federal Reserve changing interest rates. The actual federal funds rate generally lies within a range of that target rate, as the Federal Reserve cannot set an exact value through open market operations.

Another way banks can borrow funds to keep up their required reserves is by taking a loan from the Federal Reserve itself at thediscount window. These loans are subject to audit by the Fed, and the discount rate is usually higher than the federal funds rate. Confusion between these two kinds of loans often leads to confusion between the federal funds rate and the discount rate. Another difference is that while the Fed cannot set an exact federal funds rate, it does set the specific discount rate.

The federal funds rate target is decided by the governors atFederal Open Market Committee(FOMC) meetings. The FOMC members will either increase, decrease, or leave the rate unchanged depending on the meetings agenda and the economic conditions of the U.S. It is possible to infer the market expectations of the FOMC decisions at future meetings from theChicago Board of Trade(CBOT) Fed Fundsfutures contracts, and these probabilities are widely reported in the financial media.

Interbank borrowingis essentially a way for banks to quickly raise money. For example, a bank may want to finance a major industrial effort but may not have the time to wait for deposits or interest (on loan payments) to come in. In such cases the bank will quickly raise this amount from other banks at an interest rate equal to or higher than the Federal funds rate.

Raising the federal funds rate will dissuade banks from taking out such inter-bank loans, which in turn will make cash that much harder to procure. Conversely, dropping the interest rates will encourage banks to borrow money and therefore invest more freely.6This interest rate is used as a regulatory tool to control how freely the U.S. economy operates.

By setting a higher discount rate the Federal Bank discourages banks from requisitioning funds from the Federal Bank, yet positions itself as alender of last resort.

Though theLondon Interbank Offered Rate(LIBOR) and the federal funds rate are concerned with the same action, i.e. interbank loans, they are distinct from one another, as follows:

The target federal funds rate is a target interest rate that is set by the FOMC for implementing U.S. monetary policies.

The (effective) federal funds rate is achieved through open market operations at the Domestic Trading Desk at the Federal Reserve Bank of New York which deals primarily in domestic securities (U.S. Treasury and federal agencies securities).

LIBOR is based on a questionnaire where a selection of banks guess the rates at which they could borrow money from other banks.

LIBOR may or may not be used to derive business terms. It is not fixed beforehand and is not meant to have macroeconomic ramifications.

Considering the wide impact a change in the federal funds rate can have on the value of the dollar and the amount of lending going to new economic activity, the Federal Reserve is closely watched by the market. The prices of Option contracts on fed funds futures (traded on theChicago Board of Trade) can be used to infer the markets expectations of future Fed policy changes. Based on CME Group 30-Day Fed Fund futures prices, which have long been used to express the markets views on the likelihood of changes in U.S. monetary policy, theCME Group FedWatch toolallows market participants to view the probability of an upcoming Fed Rate hike. One set of suchimplied probabilitiesis published by the Cleveland Fed.

As of 26September2018updatethe target range for the Federal Funds Rate is 2.002.25%.9This represents the eighth increase in the target rate since tightening began in December 2015.10

The last full cycle of rate increases occurred between June 2004 and June 2006 as rates steadily rose from 1.00% to 5.25%. The target rate remained at 5.25% for over a year, until the Federal Reserve began lowering rates in September 2007. The last cycle of easing monetary policy through the rate was conducted from September 2007 to December 2008 as the target rate fell from 5.25% to a range of 0.000.25%. Between December 2008 and December 2015 the target rate remained at 0.000.25%, the lowest rate in the Federal Reserves history, as a reaction to theFinancial crisis of 20072008and itsaftermath. According to Jack A. Ablin, chief investment officer at Harris Private Bank, one reason for this unprecedented move of having a range, rather than a specific rate, was because a rate of 0% could have had problematic implications for money market funds, whose fees could then outpace yields.11

When theFederal Open Market Committeewishes to reduce interest rates they will increase the supply of money by buyinggovernment securities. When additional supply is added and everything else remains constant, the price of borrowed funds the federal funds rate falls. Conversely, when the Committee wishes to increase the federal funds rate, they will instruct the Desk Manager to sell government securities, thereby taking the money they earn on the proceeds of those sales out of circulation and reducing themoney supply. When supply is taken away and everything else remains constant, the interest rate will normally rise.12

The Federal Reserve has responded to a potential slow-down by lowering the target federal funds rate duringrecessionsand other periods of lower growth. In fact, the Committees lowering has recently predated recessions,13in order to stimulate the economy and cushion the fall. Reducing the federal funds rate makes money cheaper, allowing an influx of credit into the economy through all types of loans.

The charts linked below show the relation betweenS&P 500and interest rates.

July 13, 1990 Sept 4, 1992: 8.00%3.00% (Includes 19901991 recession)

May 16, 2000 June 25, 2003: 6.501.00 (Includes 2001 recession)

Bill GrossofPIMCOsuggested that in the prior 15 years ending in 2007, in each instance where the fed funds rate was higher than thenominal GDPgrowth rate, assets such as stocks and housing fell.32

A low federal funds rate makes investments indeveloping countriessuch as China or Mexico more attractive. A high federal funds rate makes investments outside the United States less attractive. The long period of a very low federal funds rate from 2009 forward resulted in an increase in investment in developing countries. As the United States began to return to a higher rate in 2013 investments in the United States became more attractive and the rate of investment in developing countries began to fall. The rate also affects the value of currency, a higher rate increasing the value of the U.S. dollar and decreasing the value of currencies such as theMexican peso.33

Fedpoints: Federal FundsFederal Reserve Bank of New York. August 2007

The Federal Reserve System: Purposes & Functions

. Washington, D.C.: Federal Reserve Board. 24 August 2011. p.4

Monetary Policy, Open Market Operations. Federal Reserve Bank. 2008-01-30. Archived fromthe originalon 2001-04-13

Reserve Requirements. Board of Governors of The Federal Reserve System. December 16, 2015.

Cheryl L. Edwards (November 1997). Gerard Sinzdak.Open Market Operations in the 1990s

BBA LIBOR – Frequently asked questions. British Bankers Association. March 21, 2006. Archived fromthe originalon 2007-02-16.

Federal Reserve issues FOMC statement(Press release).Board of Governors of the Federal Reserve System. 2018-09-26

Tankersley, Jim (2018-03-21).Fed Raises Interest Rates for Sixth Time Since Financial Crisis.

4:56 p.m. US-Closing Stocks. Associated Press. December 16, 2008. Archived fromthe originalon July 18, 2012.

David Waring (2008-02-19).An Explanation of How The Fed Moves Interest Rates. m. Archived fromthe originalon 2015-05-05

Historical Changes of the Target Federal Funds and Discount Rates, 1971 to present. New York Federal Reserve Branch. February 19, 2010. Archived fromthe originalon December 21, 2008.

$SPX 1990-06-12 1992-10-04 (rate drop chart). StockCharts.com.

$SPX 1992-08-04 1995-03-01 (rate rise chart). StockCharts.com.

$SPX 1995-01-01 1997-01-01 (rate drop chart). StockCharts.com.

$SPX 1996-12-01 1998-10-17 (rate drop chart). StockCharts.com.

$SPX 1998-09-17 2000-06-16 (rate rise chart). StockCharts.com.

$SPX 2000-04-16 2002-01-01 (rate drop chart). StockCharts.com.

$SPX 2002-01-01 2003-07-25 (rate drop chart). StockCharts.com.

$SPX 2003-06-25 2006-06-29 (rate rise chart). StockCharts.com.

$SPX 2006-06-29 2008-06-01 (rate drop chart). StockCharts.com.

Press Release. Board of Governors of The Federal Reserve System. December 16, 2008.

Open Market Operations. Board of Governors of The Federal Reserve System. December 16, 2015.

Decisions Regarding Monetary Policy Implementation. Board of Governors of The Federal Reserve System. Archived fromthe originalon 2016-12-15.

Cox, Jeff (2017-03-15).Fed raises rates at March meeting.

Federal Reserve issues FOMC statement. Board of Governors of The Federal Reserve System. June 14, 2017.

Federal Reserve issues FOMC statement. Board of Governors of The Federal Reserve System. December 13, 2017.

Federal Reserve issues FOMC statement. Board of Governors of The Federal Reserve System. March 21, 2018.

Federal Reserve issues FOMC statement. Board of Governors of The Federal Reserve System. June 13, 2018.

Federal Reserve issues FOMC statement. Board of Governors of The Federal Reserve System. December 19, 2018.

Shaw, Richard (January 7, 2007).The Bond Yield Curve as an Economic Crystal Ball

Peter S. Goodman, Keith Bradsher and Neil Gough (March 16, 2017).The Fed Acts. Workers in Mexico and Merchants in Malaysia Suffer.

Rising interest rates in the United States are driving money out of many developing countries, straining governments and pinching consumers around the globe.

Historical Data: Effective Federal Funds Rate(interactive graph) from theFederal Reserve Bank of St. Louis

Federal Reserve Web Site: Federal Funds Rate Historical Data (including the current rate), Monetary Policy, and Open Market Operations

MoneyCafe.com page with Fed Funds Rate and historical chart and graph

Historical data (since 1954) comparing the US GDP growth rate versus the US Fed Funds Rate – in the form of a chart/graph

Federal Reserve Bank of Cleveland: Fed Fund Rate Predictions

Federal Funds Rate Data including Daily effective overnight rate and Target rate

New York Clearing House Association(18531913)

Federal Open Market Committee actions(19612015)

Board of Governors, FRS v. Investment Co. Institute

Federal Reserve subprime crisis responses(20072010)

Randal Quarles(Vice Chairman for Supervision)

All Wikipedia articles written in American English

Articles containing potentially dated statements from September 2018

All articles containing potentially dated statements

Articles with dead external links from April 2019

This page was last edited on 14 April 2019, at 22:29

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