How Does the Fed Funds Rate Work, and What Is Its Impact?

The Most Powerful Interest Rate in the World

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The effective Federal Funds Rate (FFR) is the average interest rate that banks pay for overnight borrowing in the federal funds market. The Federal Reserve uses certain tools to adjust this rate, because it influences other interest rates, such as those you pay on credit cards, mortgages, and bank loans. It also affects the value of the U.S. dollar and other household and business assets. That makes it the most important interest rate in the world.

The Fed sets a target range for the FFR. It has a lower and upper bound. Below are the target ranges announced at Federal Open Market Committee (FOMC) this year.

Fed Funds Rate 2022
Date Targeted Fed Funds Rate
Jan. 26, 2022 0%-0.25%
March 16, 2022 0.25%-0.50%
May 4, 2022 0.75%-1.00%
June 15, 2022 1.50%-1.75%
July 27, 2022 2.25%-2.5%

At its September meeting, the Federal Reserve increased its target for the FFR by 0.75% to a range of 3% to 3.25% in a continued effort to wrangle rising inflation.

Key Takeaways

  • The Federal Funds Rate (FFR) is the average rate that banks pay when borrowing from each other overnight.
  • At its September meeting, the Federal Reserve announced that it would increase its target for the FFR by 75 basis points to a range of 3% to 3.25%.
  • The FFR influences the prime rate that banks charge their best, most creditworthy customers.
  • The goal is to keep the FFR in the target range to control swings in the economy. 

Rates Affected by the Fed Funds Rate

One of the most significant rates influenced by the FFR is the prime rate. That's the prevailing interest rate that banks charge their best customers. The prime rate affects many consumer interest rates, including deposits, bank loans, credit cards, and adjustable-rate mortgages.

There's a ripple effect on the London Interbank Offered Rate (LIBOR), too. The LIBOR rate is used worldwide by banks to determine interest rates charged on adjustable-rate mortgages. Its status as the relevant price index for consumer products is due to be phased out in stages throughout 2022, with a full phaseout by June 2023.

The FFR indirectly influences even longer-term interest rates. Investors want a higher rate for a longer-term Treasury note. The yields on Treasury notes indirectly drive long-term conventional mortgage interest rates.

How the Fed Uses Its Rate To Control the Economy

The FOMC uses several tools to influence interest rates and the economy. The two tools used to keep the FFR in the target rate range are:

  • Interest on reserve balances (IORB): The Fed pays interest on the reserves that banks keep with it.
  • Overnight reverse repurchases (ON RRP): The Fed sells securities to banks that aren't eligible for interest on reserve balances. It then buys them back at a higher price the next day, essentially paying the bank interest.

The committee sets a target range for the rate and then sets the IORB and ON RRP rates to manage the effective FFR. In turn, banks charge each other interest on loans that reflect these changes. These rates then dictate the rates that banks charge their customers, influencing business and consumer spending.

Influencing the FFR helps the Fed manage inflation, promote maximum employment, and keep interest rates moderate. The FOMC members monitor the core inflation rate for long-term signs of inflation and adjust the rates accordingly.

It can take months for a change in the rate to affect the entire economy. Planning that far ahead has led to the Fed becoming the nation’s expert in forecasting economic performance.

Stock market investors should watch the monthly FOMC meetings like hawks. Analysts pay close attention to the FOMC to try and decode what the Fed will do.

How the Fed Funds Rate Maximizes Employment

It's referred to as "expansionary monetary policy" when the Fed lowers the rate range. Banks offer lower interest rates on everything from credit card rates to student and car loans.

Adjustable-rate home loans become cheaper, which improves the housing market. Homeowners feel richer and spend more. They can also take out home equity loans more easily, spending that money on home improvements and new cars. These actions stimulate the economy by increasing demand.

Note

The FOMC lowered the target for the FFR twice in March 2020 in an emergency response to the COVID-19 pandemic, dropping it by a total of 1.5 percentage points. This move was an attempt to ease the impact of the pandemic on employment and spending.

Employers must hire more workers and increase production when demand increases. This decreases unemployment, increases consumers' ability to spend, and feeds more demand. The Fed then sets a target range to keep a healthy level of unemployment and inflation.

How the Fed Funds Rate Manages Inflation

The opposite occurs when the Fed raises rates. This is called "contractionary monetary policy," because it slows the economy. The cost of loans grows higher, resulting in consumers and businesses borrowing less.

Adjustable-rate mortgages become more expensive. Homebuyers may only be able to afford smaller loans, which slows the housing industry. Housing prices go down, and homeowners have less equity in their homes. They may spend less, too, further slowing the economy.

How Fed Funds Work

The Federal Reserve used to require banks to keep a percentage of their deposits on hand each night. This reserve requirement prevented them from lending out every dollar they had and ensured that they had enough cash on hand to start each business day. The Fed reduced the reserve ratio to 0% as of March 2020.

Note

The FFR's record high was 20% in 1980 and 1981. Fed Chair Paul Volcker used it to combat double-digit inflation. 

Banks can still hold capital in reserves for other banks to borrow from, and the Fed pays them interest on the reserves they keep (the IORB). A bank borrows from another bank's reserve if it is short of cash at the end of the day. That's where the FFR comes in. It's the rate that banks charge each other for overnight loans.

The balance kept in reserves are the federal funds, and the FFR is determined by the banks that lend each other money. They base their rates on the IORB and the ON RRP rates, creating the effective federal funds rate, which is the volume-weighted average of all the overnight transactions within the reserves.

The Fed maintained its target FFR range at 0% to 0.25% in January 2022, then increased it to 0.25% to 0.50% in March 2022. This is a range of 25 basis points that the effective FFR will stay within because banks won't want to pay more interest on a loan than they earn on their reserves and reverse repurchases. See more about how the Federal Reserve has set the FFR in the last few years below.

Fed Funds Rate from 2019 to 2022
Date Targeted Fed Funds Rate
Jan. 30, 2019 2.25%–2.50%
March 20, 2019 2.25%–2.50%
May 1, 2019 2.25%–2.50%
June 19, 2019 2.25%–2.50%
July 31, 2019 2.00%–2.25%
Sept. 18, 2019 1.75%–2.00%
Oct. 11, 2019 1.75%–2.00%
Oct. 30, 2019 1.50%–1.75%
Dec. 11, 2019 1.50%–1.75%
Jan. 29, 2020 1.50%–1.75%
March 3, 2020 1.00%–1.25%
March 15, 2020 0%–0.25%
April 29, 2020 0%–0.25%
June 10, 2020 0%–0.25%
July 29, 2020 0%–0.25%
Sept. 16, 2020 0%–0.25%
Nov. 5, 2020 0%–0.25%
Dec. 16, 2020 0%–0.25%
Jan. 27, 2021 0%–0.25%
March 17, 2021 0%-0.25%
April 28, 2021 0%-0.25%
June 16, 2021 0%-0.25%
July 28, 2021 0%-0.25%
Sept. 22, 2021 0%–0.25%
Nov. 3, 2021 0%–0.25%
Dec. 15, 2021 0%–0.25%
Jan. 26, 2022 0%-0.25%
March 16, 2022 0.25%-0.50%
May 4, 2022 0.75%-1.00%
June 15, 2022 1.50%-1.75%
July 27, 2022 2.25%-2.5%

Frequently Asked Questions (FAQs)

Do lenders have to reduce my interest rates when the Federal Funds Rate drops?

The Fed doesn't require that banks and lenders follow the FFR. It doesn't dictate the interest rates they charge.

Who are the FOMC members?

The Federal Open Market Committee is made up of the members of the Board of Governors of the Federal Reserve System and Reserve Bank presidents. It's a 12-member body, and some members serve on a rotating basis.

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Sources
The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy.
  1. Board of Governors of the Federal Reserve System. "Open Market Operations."

  2. Board of Governors of the Federal Reserve System. "Meeting Calendars, Statements, and Minutes (2017-2022)."

  3. Consumer Financial Protection Bureau. "CFPB Issues Final Rule to Facilitate Transition From LIBOR."

  4. Board of Governors of the Federal Reserve System. "Open Market Operations."

  5. Board of Governors of the Federal Reserve System. "Reserve Requirements."

  6. Board of Governors of the Federal Reserve System. "Changes in the Intended Federal Funds Rate, 1971-1992," Page 8.

  7. Federal Reserve Bank of St. Louis. "Visualizing the Fed's New Monetary Tools."

  8. Board of Governors of the Federal Reserve System. "Federal Reserve Issues FOMC Statement: Jan. 26, 2022."

  9. Board of Governors of the Federal Reserve System. "Federal Reserve Issues FOMC Statement.”

  10. Board of Governors of the Federal Reserve System. "About the FOMC."

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