DEFINITION: The “federal funds rate” is the interest rate at which banks and credit unions (“depository institutions”) lend “reserve balances” to other depository institutions overnight on an uncollateralized basis.
“Reserve balances” are funds belonging to depository institutions which are held by the US Federal Reserve System (“the Fed”) to meet those institutions’ reserve requirements—whence the name commonly used for this special interest rate.
ETYMOLOGY: The word “federal” derives from the Latin noun, foedus, foederis, meaning “league,” which in turn derives from the verb, fīdere, meaning “to trust.”
The word “funds” derives from the Latin noun, fundus, meaning “bottom” and, by extension, “ground,” “soil,” “farm,” “estate,” “property,” or “capital.”
For the etymology of the word “rate,” see the article prime rate.
USAGE: The basic purpose of the federal funds rate is to establish a uniform interest rate for the overnight lending of reserve-balance funds among depository institutions nationwide.
Why do such loans need to be made in the first place?
The reason is the following.
Depository institutions are legally required to maintain an account with the Fed in a minimum amount that is calculated depending on the institution’s size. These are the institutions’ “reserve balances.”
The amount of an institution’s reserve balance may fluctuate daily as the institution make deposits into and withdrawals from its account.
A depository institution with a surplus in its reserve balance account—that is, when the balance in its account is greater than required by law—is said to have “federal reserve credit.”
Federal reserve credit can be converted into federal reserve notes. Additionally, a depository institution with a federal reserve credit may lend its federal reserve credit to other depository institutions, which wish to maintain a larger reserve balance, typically for the purpose of overnight processing.
There are actually two federal rates, called the “effective” rate and the “target” rate.
The effective federal funds rate is set by the market and is published by the Federal Reserve Bank of New York every business day. Specifically, the effective rate is the median interest rate for all overnight federal funds transactions.
The federal funds target rate, in contrast, is set by the members of the Federal Open Market Committee, which meets for this purpose roughly eight times a year. Special meetings of the Committee outside of the normal schedule may also be held from time to time, as necessary.
By buying or selling government-backed securities (“Treasury bills”), the Federal Reserve strives to bend the effective rate towards the target rate. This is the Fed’s chief means of influencing the money supply of the US.
The federal funds rate also functions as a significant reference point, or “benchmark,” used by financial markets in setting the interest rates offered by depository institutions and so, indirectly, the prime rate.
The relation between the federal funds rate and the prime rate is discussed further in the article, prime rate.