In the United States, the federal funds rate is the interest rate at which depository institutions lend reserve balances to other depository institutions overnight, on an uncollateralized basis. Reserve balances are amounts held at the Federal Reserve to maintain depository institutions' reserve 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 in financial markets.
The federal funds rate is basically the rate of interest at which a financial institution (for example, a savings bank, credit union or commercial bank) lends another financial institution funds to meet the reserve requirements. These funds are provided overnight.
The Federal Reserve Bank (the central banking authority of the country) has set a minimum amount that every financial institution must hold in reserve to prevent bank failure. This reserve requirement is roughly 10 percent of the deposits.
In case a bank runs short of money and can't maintain the reserve requirement set by the Federal Reserve Bank, then the bank can borrow the money overnight from the Federal Reserve Bank or from other local financial institutes with money at the Federal Reserves. The Federal Reserve Bank charges the discount rate for overnight loans while financial institutions charge each other the Federal Funds Rate (FFR) for overnight loans.
Did you know that the Federal Funds Rate has a significant influence on the US economy including major factors like growth, employment and inflation?
The target is basically determined by the FOMC (Federal Open Market Committee). The FOMC is the monetary policy making body. This body telegraphs the target for the FFR based on the open market conditions and operations.
Over the years, this target for the FFR has widely varied because of the dynamic economic conditions. During the 1980's, the target for FFR was 20 percent. However, since then, the rate has steadily reduced. After the 2008 financial crisis, the target for the FFR came down to a record, all-time low. This was done basically to combat the recession that hit the US and simultaneously boost the country's economy.
Here, it is important to understand that when the federal funds rate is high, it becomes extremely difficult for financial institutes to borrow overnight loans as it is too expensive. Therefore, these loans are only offered to those institutes that have good creditworthiness and have the ability to return the money in due time.
Financial education is so important, but barely taught at all in our schools. Having resources online is great, but not if they are inaccessible to so many. Thanks 508!