Federal Funds Rate: Definition, History & Impact

When banks loan excess reserve funds to each other overnight, the interest they charge is called the “federal funds rate.” It's what media outlets refer to when they mention interest rates.

The Federal Open Market Committee (FOMC) determines its upper and lower limits. In turn, the federal funds rate affects short-term and long-term financial interest rates, such as those on your personal loans, mortgages and credit cards.

All banks need to have enough funds in their reserves to ensure they can facilitate withdrawals and other financial obligations. They can have it as cash on hand or account balances in a Federal Reserve bank.

A reserve requirement ratio determines the amount they need as a reserve. For example, if a bank has $150,000,000 in deposits and its reserve requirement ratio is 10%, it must have at least $15 million in cash reserves.

However, sometimes, if a bank doesn’t have the required cash reserve amount on hand, it can borrow from other banks whose reserves exceed their requirement.

It's where the federal funds rate comes in. Commercial banks use it as the interest rate when they overnight lend their excess reserve funds to other banks.

After defining the federal funds rate, let's explore how it's determined. Two factors come into play. First, there's the Federal Open Market Committee (FOMC), which is the committee that determines the federal funds rate.

Second, there's the Open Market Operations (OMO). It's one of the Federal Reserve's tools to implement monetary policy, along with reserve requirements and discount rates. The OMO also affects the federal funds rate.

The FOMC consists of 12 members — the seven Governors of the Federal Reserve System and eight presidents from the 12 Federal Reserve Banks, one of which is always the president of New York's Reserve Bank. They meet about eight times during the year. They can hold more meetings if needed.

These meetings focus on reviewing the country's current economic conditions. Based on these, the FMOC determines whether or not the monetary policy should change, which may include increasing or decreasing the federal funds rate.

The committee also oversees Open Market Operations, which the Federal Reserve uses to execute monetary policy by buying and selling securities or government bonds.

Purchasing bonds increase the Federal Reserve's money supply, which means they have more money to lend. It typically causes interest rates to decrease because banks prefer to loan consumers funds.

On the contrary, when the Federal Reserve sells bonds, it decreases the amount it can lend. Increasing the interest rate is one way for banks to make the most out of their limited supply of funds.

Interest on reserve balances previously used different rates. One is the Interest on Required Reserves (IORR), while the other is the Interest on Excess Reserves (IOER). However, the Board decided to consolidate it to one interest rate, effective last July 29, 2021.

The IORB applies to master accounts held at the Federal Reserve Banks. Having one interest rate instead of two makes it easier to calculate the amount of interest owned on these balances. It also serves as the upper limit basis point for the federal funds rate.

If there's an upper limit for the federal funds rate, there must also be a lower limit — Overnight Reserve Repurchases (ON RRP).

When a bank can't meet its capital requirement, it can purchase some securities from the Federal Reserve, such as treasury bills, notes or government bonds. Part of the agreement is that the Federal Reserve will repurchase it later, usually the next business day.

When the Federal Reserve repurchases the securities, it pays a higher price than what it was sold for, allowing the bank to earn interest.

Source: Federal Funds Effective Rate

The federal funds rate is currently between 2.25% to 2.5%. These percentages are always subject to change. Since the FMOC determines the federal funds rate, their economic reviews and financial conditions, the upper and lower limits are expected to change over time.

The upper and lower limits have remained at 0% and 0.25% for nearly seven years, stretching from 2008 to late 2015. The first incremental increase occurred mid-Dec. of 2015. You'll notice the same pattern until July 2019 — at this point, the upper and lower limits were at 2.25% and 2.5%, respectively.

In March of 2020, upper and lower limits dropped to 0% and 0.25%, respectively. It's crucial to note that while the incremental increases spanned three and a half years, the drop happened within seven months.

The federal funds rate was at its highest in the 1980s, which was the Federal Reserve's approach to battling a 14.6% inflation rate. Since then, it's dropped to 0% twice. Once in 2008, due to the Great Recession, and again in 2020, because of the COVID-19 pandemic.

When the Federal Reserve implements monetary policy, it does so with the following objectives in mind:

• To promote maximum employment
• To have stable prices
• To keep long-term interest rates at a moderate level

Although there are three goals, it is known as the dual mandate because the first two make the third possible.

A holistic understanding of the federal funds rate involves knowing the Federal Reserve's dual mandate. Its monetary policy is geared toward two things.

The first is maintaining maximum employment, also known as full employment. The Federal Reserve doesn't aim to zero out unemployment. The objective is to reach the highest level of employment possible without experiencing excessive inflation.

The second is maintaining price stability and moderate long-term interest rates. When deflation or rapid inflation occurs, the economy becomes unstable. Economic instability may also lead to investors losing confidence, fewer investments or even a recession.

Because of its dual mandate, controlling inflation and deflation becomes part of the Federal Reserve's responsibility. Its ability to adjust the federal funds rate helps combat the former or stimulate the economy to break out of the latter.

Another tool the Federal Reserve uses to influence the economy is “forward guidance,” which lets the public know what the monetary policy will likely be. However, it does not explicitly state what the Federal Reserve intends to do. Instead, the communication focuses on the conditions that may cause it to stay or change its course. In turn, it influences the public's financial decisions.

Although the Federal Open Market Committee (FOMC) determines the federal funds rate, it cannot impose it on banks when they lend each other funds. The best they can do is ensure that the interest rate falls within an upper and lower limit. Based on an earlier section, we know that the upper limit is the Interest on Reserve Balances (IORB). On the other hand, the Overnight Reserve Repurchases (ON RRP) rate serves as the lower limit.

However, commercial banks cannot use a range to charge interest. Instead, the final figure is a result of their negotiations called the “effective federal funds rate.”

Source: Federal Funds Effective Rate

The effective federal funds rate (EFFR) trend is similar to that of the upper and lower limits. It’s best to note what years had the highest and lowest rates.

Although the economy already saw double-digit EFFRs in the early and mid-70s, it wasn't until after February 1980 that they exceeded 15%. In March of 1980, the EFFR hit 17.19%. Unfortunately, it became even higher the following month.

The highest EFFR was on Jan. 1 and June 1 in 1981. It hit an all-time high of 19.08% and 19.10%, respectively. Remember, inflation rates were extremely high, and the Federal Reserve raised interest rates to control it.

In recent years (2008 onwards), the EFFR almost always has been below 0.20%. In 2016, it started increasing. Its upward path continued until it reached nearly 2.5% from December 2018 to around July 2019.

Drastic drops happened in early 2020, from 1.5% to 0.05% in three months. This timeline coincides with the Federal Reserve's decision to decrease the federal funds rate to 0% because of the global pandemic.

Knowing the definition of the federal funds rate is one thing. Understanding how it impacts the average American is something else.

Since we've been discussing everything from a macroeconomic perspective, it may be easy to dismiss the federal funds rate as something that affects lending between commercial banks more than the average individual. Unfortunately, that's not the case.

Remember that it influences other interest rates, which means you'll feel its impact on any debt you may have, whether it be a personal loan or credit card

Any economic instability caused by inflation or deflation goes against the Federal Reserve's dual mandate. When the economy enters one of these periods, the Federal Reserve uses the federal funds rate to control it.

The second portion of the dual mandate relates to inflation (and its opposite, deflation). Price stability becomes a thing of the past if rates of goods and services either increase or decrease too rapidly or for extended periods.

During inflation, you need to spend more funds to acquire the same amount of goods or services. It's typically a result of supply outpacing the demand of the market. When the Federal Reserve increases the IORB and the ON RRP (and, as a result, the federal funds rate), commercial banks earn more interest if they put more money in Reserve Banks or purchase securities from the Federal Reserve.

This shift in how banks operate makes borrowing more expensive because the interest rate they charge customers also increases. People tend to delay borrowing, resulting in less spending. After a while, the decrease in demand begins to lower the inflation rate.

In contrast, lowering the federal funds rate is a strategic move when deflation happens. Lower interest rates make borrowing attractive — households and businesses have more funds to spend. These go back into the economy in the form of purchases or expansions.

Source: Federal Funds Effective Rate, FRED Inflation Rate

The graph above shows how inflation rates change after the Federal Reserve adjusts the federal funds rates. Over several years, each time the Core CPI peaks, the typical response is an increase in interest rates. The effect is apparent — decreased inflation rates typically follow.

You can also observe the opposite. When inflation rates become too low (the Federal Reserve usually aims for 2%), the federal funds rate also decreases.

The effect of the federal funds rate may be more apparent at a macroeconomic level, but it doesn't mean that consumers don't feel it. When it shifts, we notice changes in interest rates in everyday financial products.

Credit card loans amounted to $820 billion in the last quarter of 2020, and more than 191 million Americans use credit cards. Consumers shopping around for a new card should always check rates and fees, such as credit card interest rates.

The interest on a credit card is variable and based on the prime rate — the interest issuing banks charge their best customers. The better your credit score, the closer your interest is to the prime rate. Conversely, banks offer consumers with poor credit rates further from it.

When the federal funds rate increases, the prime rate also increases. As a result, you pay more in interest. When the Federal Reserve cuts interest, the prime rate lowers — so even if you used the same amount of credit, the amount you pay in interest is lower.

Credit card users aren't the only ones affected when the federal funds rate changes. Those who purchased cars would also feel the ripple effect, especially if you opted to finance it by taking out an auto loan.

The auto loan debt in the U.S. as of Q3 of 2021 was at $1.43 Trillion, a record high. Car owners have an average balance of $20,987. Fortunately, most car loans have fixed-rate interests, so even if the federal funds rates increase, your monthly payments won't increase if you've already locked in your rates.

Unfortunately, those who choose to secure a loan with variable rates may have a different experience. It may have seemed like a better idea in the beginning since variable-rate loans tend to charge a lower interest rate than fixed-rate ones. However, an increase in federal funds rates also reflects a rise in auto loan rates. Since the Federal Reserve has hiked up the upper and lower limits four times since mid-March, you can expect your monthly payments to also increase.

New auto loan borrowers may face challenges finding affordable interest rates, despite having good credit standing. Paying more interest increases your monthly payments, which takes a considerable portion of your budget.

The federal funds rate affects homebuyers and homeowners. Homeownership in the U.S. was at 65.8% as of Q2 of 2022. Many people with a mortgage can feel the effects of the high federal funds rate.

Mortgages are more sensitive to shifting interest rates. There are various types of mortgages, but based on interest rates, they fall under one of two categories — fixed-rate or adjustable-rate.

Prospective homebuyers typically prefer conventional, fixed-rate mortgages because you can calculate your monthly amortization, allowing for better budgeting. However, the continuous increase in Federal Funds Rates has also caused mortgage rates to increase. The interest for 30-year fixed-rate mortgages has risen from 4.16% to 5.22% between March 17 and Aug. 11. You can see the same trend for 15-year fixed-rate mortgages, which went from 3.39% to 4.59%

Those figures make adjustable-rate mortgages more attractive. However, they are more susceptible to federal funds rate increases, making repayment tricky.

Changes in interest rates may also affect your decision to refinance your mortgage. You usually do this to save money or increase home equity by finding shorter loan terms or more affordable rates. Unfortunately, current rates are just as high (if not higher) as yours.

For the 2020-2021 academic year, tuition and fees in a four-year institution averaged $9,400 to $36,700, depending on whether it was public, private nonprofit or private for-profit. A student loan allows you to afford it, but it also means you'll be affected by changes in the federal funds rate.

With current college costs, it isn't surprising that people look to student loans to fund their education. Consequently, student loan debt in the U.S. has reached $1.748 trillion. Although most graduates have been able to manage it, a shift in the federal funds rate may make it difficult in the future.

The exceptions are those whose student loans have fixed interest rates because those won't change, regardless of the Federal Reserve's monetary policy. An increase in the federal funds rate won't result in higher interest. However, the opposite is true — your interest rate remains unchanged even if the Federal Reserve decides to cut down rates.

However, not all students have fixed rates, especially those who took out private ones. A loan with variable interest is sensitive to changes in the federal funds rate. Depending on the Federal Reserve's monetary policy, the amount you pay in interest increases or decreases over time.

Like homeowners with mortgages, changes in the federal funds rate may also cause you to reconsider whether it's best to refinance your loan or not. Remember, if you can't find a lower rate, you may be better off with what you currently have.

The federal funds rate is a crucial macroeconomic concept, but it can be overwhelming. Take a look at the section below for the most commonly asked questions about the federal funds rate.

The federal funds rate is an essential macroeconomic subject, and, as you’ve read through this guide, you may have encountered other concepts that are unfamiliar. Fortunately, MoneyGeek has got these concepts covered. Browse the below resources for a more holistic macroeconomic understanding.

• Demand: How much people are willing to spend for a product or service affects our economy. Find out how demand is calculated and how it relates to supply.
• Supply: Supply refers to the number of goods or services available to consumers. Along with demand, it plays a crucial role in determining prices. MoneyGeek’s page introduces the different types of supply and related concepts.
• Economic Recessions: History, Causes and Characteristics: You may have heard the term recession (especially in recent times), but do you know what it really means? MoneyGeek’s page explores it exhaustively and provides all the necessary information.
• Inflation in Economics: Types, Causes and Indexes: Everyone’s wary of inflation, but how does it affect you personally? This page explores various types of inflation and their causes. With an understanding, you may have more of an appreciation of its effects on the average American.
• Stagflation in Economics: History, Causes and Characteristics: Most people have heard about inflation. Some are familiar with deflation. But how much do you know about stagflation? Learn more about it: its history and causes.