The federal funds rate is the interest rate at which depository institutions lend balances (federal funds) at the Federal Reserve to other depository institutions overnight. It is not (as the name might initially suggest) the rate at which the Fed lends to financial institutions. That is the discount rate.

Here is how the system works:

• U.S. banks and thrift institutions are obliged by law to keep certain no-interest-bearing reserves with the Fed (or to keep an equal amount of vault cash, but this imposes risks and costs). The level of these reserves is determined by the outstanding assets and liabilities of each depositary institution, but is typically 10% of the total value of the bank's demand accounts.
• Assume that a particular U.S. depositary institution (Bank A) needs additional money in order to keep its reserve at the Fed at the legally required level. To this purpose, it will borrow the requisite funds from another bank (Bank B) that has a surplus in its Fed reserves. The interest rate that Bank A will pay to Bank B in return for borrowing the funds is negotiated between the two banks, and the weighted average of this rate across all banks is the effective Federal Funds Rate.

The nominal rate is a target set by the governors of the Federal Reserve, which they enforce primarily by open market operations (the buying and selling of bonds). When the media refer to the Federal Reserve "changing interest rates," this nominal rate is almost always meant.

Historical Rates

External links

• Federal Reserve Web Site: Federal Funds Rate History (including the current rate), Monetary Policy, and Open Market Operations

• MoneyCafe.com page with Fed Funds Rate and historical chart and graph

Federal Reserve | Interest rates

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