federal funds rate

Federal funds rate

The interest rate that banks with excess reserves at a Federal Reserve district bank charge other banks that need overnight loans. The Fed funds rate, as it is called, often points to the direction of US interest rates. The most sensitive indicator of the direction of interest rates, since it is set daily by the market, unlike the prime rate and the discount rate.

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federal funds rate

The rate of interest on overnight loans of excess reserves made among commercial banks. Because the Federal Reserve has significant control over the availability of federal funds, the rate is considered an important indicator of Federal Reserve monetary policy and the future direction of other interest rates. A declining federal funds rate may indicate that the Federal Reserve has decided to stimulate the economy by releasing reserves into the banking system. Care is needed in using this indicator, however, because a declining rate may simply mean that the banks have weak demand for commercial loans and little need for borrowing reserves.

Case Study The Federal Reserve announced in early December 2001 it was lowering its target federal funds rate from 2.00% to 1.75%, the lowest level in 40 years. The quarter-point decline represented the 11th reduction in the benchmark short-term interest rate since the beginning of the year and established a target rate lower than the rate of inflation. The federal funds rate represents the rate that banks pay to borrow reserves from other banks. This rate influences other short-term rates, including the prime rate and the interest rate on U.S. Treasury bills. The aggressive Federal Reserve policy toward reducing interest rates was intended to stimulate a weak economy that had produced rising unemployment and business failures, especially following the September 11 terrorist attacks in New York City and Washington, D.C. The Federal Reserve has tools available to affect short-term interest rates but not long-term rates, which are influenced by inflation expectations of lenders and borrowers. Thus, an aggressive policy by the Federal Reserve to reduce short-term rates and stimulate the economy can actually result in higher long-term rates as investors become concerned that increased economic activity will be accompanied by rising inflation.