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About Federal Funds Rate
Just like borrowers borrow money from banks when they require financial assistance, banks might also need financial aid to continue their lending business.
When you take a loan, the bank will charge you an interest rate according to the current market for providing you with the money you need.
Similarly, when a bank borrows money from another bank or lending institution, there is an interest rate that is charged based on the federal funds rate. In this post, we will understand what is the feds fund rate in detail.
What Is The Federal Funds Rate?
The federal funds rate is one of the Federal Reserve’s important tools for managing US monetary policy.
As it affects everything from the annual percentage rate (APR) that individuals earn on savings accounts to the interest rate individuals pay on their credit card balances, the Fed funds rate essentially determines the cost of money in the U.S. economy.
The term Fed funds rate refers to the interest rate index set by the FOMC (Federal Open Market Committee).
This rate index is the rate at which commercial lenders and banks borrow and lend their excess reserves overnight to each other.
The FOMC, the Federal Reserve’s policymaking body, meets eight times a year to set the index for the fed funds rate as a part of its monetary policy. This policy is used to encourage economic development.
How Does Federal Funds Rate Work?
This rate refers to the interest that banks charge other financial institutions for lending them excess cash from their reserve balances overnight.
According to the law, banks must maintain a reserve that is equal to a certain percentage of their deposits in an account with the Federal Reserve Bank.
The amount of money a bank must keep in its Federal Reserve Bank account is called the minimum reserve requirement and is based on a percentage of the lender’s or the bank’s total deposits.
Banks and lenders are required to maintain money-making accounts with the FED banks to ensure they have enough cash to cover deposits and other liabilities.
Any money in their reserve that exceeds the required level is available for borrowing from other banks that may be falling short of finances.
The end-of-the-day balances in the lender’s or the bank account averaged over two-week reserve maintenance periods are used to determine whether it meets its minimum reserve requirements.
If the bank has a balance of more than the minimum required reserves in the account, the additional reserves could be used for lending to other financial institutions that are expecting a shortfall of funds.
For this overnight transaction between two banks, the lending bank will charge an interest rate based on the Fed funds rate.
The Federal Open Market Committee decides about rate adjustments based on important economic signals that may show signs of recession, inflation, or other problems that can affect sustainable economic development.
The signals may include factors like the durable goods orders report and the core inflation rate.
The index for the federal funds rate has changed widely over the years in response to the different economic conditions. Due to inflation in the 1980s, the fed fund rate was set as high as 20%.
While during The Great Recession of 2007 to 2009, the rate dropped to a record low target of 0% to 0.25% in an attempt to motivate economic development.
Conclusion
The federal funds rate doesn’t just affect interest rates for the financial institutions. It also affects the entire country’s economy. The feds funds rate affects the stock market as well.
For example, when the Fed cuts rates, stock markets typically rise because borrowing costs for public companies must fall, making it cheaper to expand their businesses and increase profits.
But when rates rise, equity markets can become more difficult as borrowing becomes more expensive and borrowing banks are charged with higher rates.
