The Federal Funds Effective Rate

The federal funds rate (FFR) is the Federal Reserve’s target interest rate at which banks lend money to each other overnight. The rate is set by the Federal Open Market Committee [(FOMC)]( when it meets eight times a year. The FFR is important because it influences the prime rate, which is the basis for many other interest rates.

Money that banks hold in reserve are referred to as “federal funds.” Some banks may have surplus liquid cash at the end of the day while others may experience shortfalls. In order meet reserve requirements, banks borrow in the overnight market.

The average rate at which banks lend to each other overnight is referred to as the “effective federal funds rate.” The effective FFR is directly influenced by the upper and lower limits of the Fed’s target FFR. The upper limit on the FFR is defined by the interest rate on reserve balances (IORB) while the lower limit is determined by overnight reverse repurchase agreements (ON RRP).

The FFR is a central component of the Fed’s monetary policy. The Fed raises the target rate wants to cool the economy down and prevent inflation from getting out of control. The Fed lowers rates when it predicts that the economy is headed toward a recession.

Frequently, the Feds efforts to cool the economy can lead directly to a recession because of the effects that higher interest rates have on the broader economy. Thus it is common to hear pundits prognosticate about whether the Fed can engineer a “soft landing” by taming inflation while avoiding a major downturn.

Sometimes the Fed can keep rates elevated in the context of a continued expansion as it did under Alan Greenspan’s leadership in the mid-1990s, but more often than not rising rates portend the beginning of the end of an expansionary phase.