Wall Street has become fixated on the federal funds rate over the past few years — and for good reason. The effective federal funds rate (EFFR) is set by the Federal Open Market Committee (FOMC). It affects the lending rates commercial banks charge each other for lending excess cash from their reserves. In doing this, however, the federal funds rate affects lending rates across virtually all financial institutions.
Indeed, the federal funds rate is also referred to as the benchmark rate because it directly and indirectly dictates lending conditions across industries in every corner of the country. Thus, it’s used as a “benchmark” against which other interest rates are measured.
The benchmark rate affects mortgages, business loans, car loans, treasury yields, credit card APRs, the stock market, and more. As such, the level of the federal fund rate plays a major role in how the economy functions.
At its core, the federal funds rate is a tool by which the Federal Reserve affects the money supply. Indeed, eight times a year, the central bank meets to decide whether to change the benchmark rate to meet its macroeconomic goals related to inflation and unemployment. These meetings are appropriately referred to as FOMC meetings.
Fractional Banking and the Reserve Requirement
As mentioned, the federal funds rate sets the interest rate that banks charge other financial institutions for lending cash from their excess reserves. This begs the question: What exactly are a bank’s excess reserves, and why do banks need to loan each other cash?
Well, this goes back to the fractional banking system. In the U.S., banks are required to maintain a percentage, or “fraction,” of their deposits in reserve for withdrawals; this is known as its reserve requirement.
Reserve requirements are also determined by the Federal Reserve. These holding requirements are another tool by which the central bank affects the money supply. During times of economic contraction, the Fed typically lowers the reserve requirement, allowing banks to lend out more cash and encourage the free flow of money into the economy. At the start of the Covid-19 pandemic, for example, the Fed lowered the reserve requirement to 0%!
On the other hand, if the economy is running too hot, the central bank may raise the reserve requirement. This decreases the money supply and increases the cost of money. The intention would be to slow inflation or bring unemployment into better balance.
On an overnight basis, a bank may have more cash on hand than is required by the reserve requirement; this is referred to as its excess cash. Banks may lend out their excess cash to other banks that anticipate having a net negative balance relative to their requirements. In this case, the lending bank would charge the receiving bank the federal funds rate in interest.
The Effective Federal Funds Rate
The Fed will change the benchmark rate to achieve various macroeconomic goals, typically related to its dual mandate: keeping inflation and unemployment at low yet sustainable levels.
The funds rate is always a range of rates that banks use as a guide for their overnight loans. For example, during the pandemic, the fed funds rate dropped to between 0% and 0.25%. The Fed can’t actually mandate a specific rate be used, so the effective federal funds rate is actually the volume-weighted median of all the overnight transactions commercial banks make with each other.
The effective federal funds rate was as high as 20% in the early 1980s, only to be slashed to near 0% when the Great Recession hit in 2007.
Rate hikes and cuts typically occur in 0.25% or 0.50% increments, as larger increases can shock the system and create undesirable side effects on the economy. However, there are a number of exceptions to this rule.
Interest Rates Today
In March 2022, the Fed began raising rates from its near 0% pandemic level to combat rampant inflation. This historically fast rate hike cycle concluded in July 2023 after 11 rate increases, bringing the benchmark rate to between 5.25% and 5.5%. It has remained there since then, despite cries from financial operators to lower interest rates.
This is considered a restrictive level for the benchmark rate, driving the 30-year mortgage rate to over 8% at times and generally impeding economic expansion. Though, as mentioned, compared to other times in U.S. history, it’s relatively mild.
In December 2023, Fed Chair Jerome Powell revealed plans to cut interest rates at least three times in 2024. That would bring the benchmark rate to around 4.6%. However, persistent inflation has slowed the process dramatically, leading to rates being untouched through the first five months of the year. Some have speculated the central bank may only cut rates once in 2024, if at all.
On the date of publication, Shrey Dua did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.
