Federal Funds rate: Overview
The Federal Funds rate is the interest rate at which banks and other depository institutions lend and borrow money overnight with each other to meet their reserve requirements set by the Federal Reserve.
The Federal Reserve sets a target range for the Federal Funds rate, and the actual rate is determined by market forces based on supply and demand for funds in the banking system. When the Federal Reserve raises or lowers the target range for the Federal Funds rate, it can affect the cost of borrowing for consumers and businesses, as well as impact economic growth and inflation.
When the Federal Funds rate is low, banks can borrow money from each other at a cheaper rate, which can lead to lower interest rates on loans for consumers and businesses. This can stimulate economic growth and spending. On the other hand, when the Federal Funds rate is high, borrowing costs for banks can increase, which can lead to higher interest rates on loans for consumers and businesses, and potentially slow down economic growth.
The Federal Funds rate is an important tool used by the Federal Reserve to influence monetary policy and achieve its dual mandate of promoting maximum employment and stable prices. By adjusting the Federal Funds rate, the Federal Reserve can influence the overall level of interest rates in the economy, which can impact borrowing, spending, and investment decisions made by consumers and businesses.
why is it range
The Federal Funds rate is set within a target range because it allows the Federal Reserve to have some flexibility in its monetary policy decisions. The target range is set by the Federal Open Market Committee (FOMC), which is the policy-making body within the Federal Reserve System.
The FOMC sets the target range based on its assessment of the current economic conditions and its outlook for future inflation and employment. The range is typically a half percentage point wide, and the midpoint of the range is considered the target rate.
By having a range instead of a single rate, the Federal Reserve can communicate its policy stance while still allowing for some variation in the actual interest rates that banks charge each other. This allows the Federal Reserve to respond to changes in economic conditions and adjust its policy stance as needed to achieve its dual mandate of promoting maximum employment and stable prices.
The range also provides some predictability and stability for financial markets, as investors and businesses can anticipate the likely direction of interest rates based on the Federal Reserve’s policy statements and actions.
Breaking it down
How the Federal Funds rate works between two banks:
Banks are required to hold a certain amount of money in reserve to ensure they have enough funds to cover withdrawals and other transactions.
If a bank finds that its reserves are below the required level, it can borrow money from other banks that have excess reserves.
The borrowing bank contacts another bank to request a loan for an overnight period (i.e., until the next business day).
The lending bank reviews the borrowing bank’s creditworthiness and assesses the level of risk before agreeing to lend money.
The two banks agree on the interest rate at which the lending bank agrees to lend money to the borrowing bank. This becomes the effective federal funds rate (EFFR)
At the end of the day, the borrowing bank transfers the borrowed funds to the lending bank’s account at the Federal Reserve, along with interest charged by the lending bank.
The next business day, the borrowing bank repays the loan principal and interest to the lending bank.
The Federal Reserve tracks all transactions between banks and calculates the effective Federal Funds rate based on the weighted average of all transactions during the day.
The Federal Reserve can set a target range for the Federal Funds rate and use open market operations (buying or selling securities) to influence the actual Federal Funds rate toward its target rate.
This process of borrowing and lending between banks in the Federal Funds market helps ensure that banks have sufficient funds to meet their reserve requirements and facilitates the smooth functioning of the overall financial system.
The effective federal funds rate (EFFR)
The effective federal funds rate (EFFR) is calculated as the effective median interest rate of overnight federal funds transactions during the previous business day. It is published daily by the Federal Reserve Bank of New York.
The Federal Reserve enforces the effective Federal Funds rate through its open market operations, which involve buying or selling government securities in the open market.
If the Federal Reserve wants to lower the Federal Funds rate, it can buy government securities from banks, which increases the amount of reserves held by the banks and puts downward pressure on the Federal Funds rate. Banks now have excess reserves, which they can lend out to other banks at a lower interest rate, causing the Federal Funds rate to fall.
On the other hand, if the Federal Reserve wants to raise the Federal Funds rate, it can sell government securities to banks, which decreases the amount of reserves held by the banks and puts upward pressure on the Federal Funds rate. Banks now have fewer excess reserves, which makes it more expensive for them to borrow from other banks, causing the Federal Funds rate to rise.
Effective Fed Rate in the last 10 years
And next we see the effective Fed Rate in the boundaries of target range EFFR and target Fed Rate in the last 3 month
There is some beauty in this mechanism. It users the power of market. We can ask the question: can’t FED just forbid commercial banks to make inter banking loans outside of the target range ?
Why just not forbid rates outside the range?
FED does not have the authority to directly control the lending behavior of individual commercial banks, including the interest rates they charge on interbank loans. While the Federal Reserve can set a target range for the Federal Funds rate, it cannot directly dictate the interest rates that banks charge on interbank loans. Interbank lending rates are influenced by a variety of factors, including supply and demand for funds, credit risk, and competition among banks.
Additionally, forbidding banks from making interbank loans outside of the target range could have unintended consequences, such as reducing the availability of credit to certain banks or increasing the risk of liquidity shortages in the banking system. Therefore, the Federal Reserve relies on its monetary policy tools to influence interest rates indirectly and maintain stability in the financial system.
What is OBFR
OBFR refers to Overnight Bank Funding Rate that is published by the Federal Reserve Bank of New York (not the FED)
While EFFR is calculated as a volume-weighted median of overnight federal funds transactions among depository institutions.
In contrast, the OBFR is calculated as a volume-weighted median of overnight transactions in the unsecured interbank market, including both federal funds and Eurodollars. With that, unlike the EFFR, the OBFR is not a policy rate and is not directly controlled by the FED.