Whenever commercial banks have a shortfall, they borrow from other commercial banks to cover up for emergencies. While paying back the debt, they pay an interest known as the federal or fed funds rate because of such emergency borrowing.
The Federal Open Market Committee (FOMC) sets this target interest rate. FOMC is the monetary policy-making body of the Federal Reserve System.
The Federal Reserve uses this interest rate to influence other interest rates including credit cards, mortgages, and bank loans.
Additionally, this interest rate affects the value of the U.S currency as well as other home and business assets. As a result of this, the fed funds rate appears to be the most relevant interest rate worldwide.
About the Federal Funds Rate
This is the interest rate that a bank charges another bank for lending to them excess money overnight from their reserve balances. The law stipulates that all banks must have a reserve that is equal to a specific percentage of their deposits in an account at the Federal Reserve bank.
The cash which the bank is required by law to keep in the Federal Reserve bank is called a reserve requirement. This reserve requirement depends on the percentage of the bank’s total deposits.
In addition, banks are required by law to keep non-interest-bearing accounts at Federal Reserve banks so that they will have enough funds to meet up with withdrawals and other necessities from their customers.
Once the bank’s reserve requirement is more than the required level, the excess funds will be available for lending to other banks that experience a shortfall overnight.
The government uses the federal funds rate to control the money supply thereby controlling inflation. Whenever the fed funds rate is low, banks will have to borrow money (reserve requirement) from each other.
This helps banks to use the reserve requirement to grant more loans thereby, in turn, boosting the economy.
On the other hand, the FOMC may decide to increase the target for the federal funds rate if they want to keep things moving slowly.
Once this happens, the rate at which banks borrow from each other will reduce. It will also reduce the number of new loans that customers and businesses get.
How does the Fed Funds Rate work?
The Federal Reserve bank requires all banks to maintain a reserve requirement that is equal to a percentage of their deposits with them.
Once banks have this reserve, they cannot lend all their money out. This thereby makes enough money available to them to start a business every day.
Banks keep the reserve requirement in their vaults or at the local Fed branch. Whenever a bank runs out of cash, it goes to another bank that has extra cash to borrow.
The amount which the bank lends to another bank is called federal funds.
If the Federal Open Market Committee (FOMC) lowers the rate, the Fed will buy securities from member banks. This thereby credits the bank’s balance sheets and makes them have more reserves than they need.
As a result, the bank will be forced to lower the federal funds rate to enable them to loan out the extra cash to other banks that have a shortfall. You can now see how the FOMC lowers interest rates.
When the Fed wants rates higher, it does the opposite. It sells its securities to banks and consequently removes funds from its balance sheet. This transaction gives banks fewer reserves, which allows them to raise rates.
Another tool that the Federal Reserve has is the discount rate. The Federal Reserve keeps this discount rate above the fed funds rate and it is what the Fed charges banks to borrow from it directly through the discount window.
5 Impact of the Federal Funds Rate
Here are the impacts of the federal funds rate:
1. Credit Card Rates/Discount Rate
Most credit cards have fluctuating interest rates. They are tied to the rate at which banks charge their preferred customers with good credit.
The prime rate depends on the federal funds rate. That is to say; if the Federal Reserve increases or decreases its target interest rate, the prime rate will eventually rise or fall along with it.
There will be a huge impact on the interest rates of credit cards and other loans because they require the risk-profiling of consumers that need credit to make purchases.
If the prime rate rises, the money market and the certificate of deposit (CD) also rise. This results in a huge boost in the savings of consumers and businesses.
The impact could be that customers that are in debt will have to pay off their debts so as to offset the high fluctuating rates that are tied to credit cards, home loans, or other debt obligations.
3. Mortgage Rates
A rise in mortgage rates can cause home borrowers to rush quickly so as to seal a deal on a new home for a fixed loan rate.
There is a simultaneous fluctuation in mortgage rates which produces domestic ten-year Treasury notes that are affected by interest rates.
Hence, if interest rates are lowered, mortgage rates will equally decrease. This shows that the cost of purchasing an apartment will be cheaper if mortgage rates are lowered.
4. Auto Loan Rates
Automobile companies continue to enjoy huge benefits from the zero-interest policy of the Federal Reserve. However, a rise in the interest rate will bring about an increment.
If the interest rate on auto loans is lowered, customers will buy more cars.
Statistics show that as of October 28, the average rate on a five-year new car loan is 4.22 percent down from 4.6 at the start of the year.
5. Business Profits
If the interest rate increases, banks gain more because it enables them to earn more profits on the loans that they give out.
Other business also gains whenever the interest rate rises because they will have enough money to expand.
However, markets that are in a recession usually do not gain whenever the interest rate rises. If the interest rate is lowered, the profits of many businesses will increase.
This will make them get enough funds with cheaper financing and make investments that will not cost them much.
What is the current Fed Funds Rate?
The Fed maintained its target for the federal funds rate between 0% to 0.25% on the 5th of November, 2020. Its aim for maintaining this interest rate is to boost the economy that has been hit by the coronavirus pandemic.
The Federal Open Market Committee (FOMC) meets eight (8) times every year to make decisions regarding the fed funds rate.
During the FOMC’s meeting in September 2020, it said that the interest rate will be maintained at the current lower rate until inflation is at 2%.
The FOMC said that it will allow inflation to increase above 2% in the short term so that the employment rate will increase rapidly.
The FOMC does not expect this to occur until the next three years, hence, the interest rate will be low during that duration.
Federal Funds Rate vs Discount Rate
The discount rate is the interest rate that the Fed sets and gives to member banks and savings that require borrowing money in order to avoid their reserves from dipping falling below the legally required minimum. It is also known as the Primary Credit Card Rate.
A discount rate can occur when a bank loans excess money and/or experiences several withdrawals on a particular day. During the discount window, banks that have shortfalls borrow from each other overnight.
If the discount rate increases, the mortgage interest rates will also increase.
Any time the discount rate increases, the prime rate will equally increase. If this happens, there will be reduced demand for new loans and mortgages.
If the FOMC lowers the discount rate, the prime rate will decrease and mortgage interest rates may fall to more favorable levels.
While Federal Funds Rate is the interest rate that a bank charges another bank for loaning out excess money overnight from their reserve balances to them.
That is to say, banks can avoid borrowing directly from the Federal Reserve through the discount window and borrowing from another bank.
The Fed Funds Rate does not fix the federal funds rate instead, it set the target rate and works to maintain it for a certain period by buying or selling government bonds.