What is the federal funds rate?

What is the federal funds rate?

• A. The interest rate at which funds borrowed and lent in the federal funds market.
• B. The rate charged on consumer loans for autos.
• C. The rate the Fed charges on discount window loans.
• D. The rate for international currency swaps.

Answer: (A)

The federal funds rate is the interest rate at which depository institutions lend reserve balances to each other overnight in the federal funds market. Banks hold these reserves to meet regulatory requirements and to settle payments. When one bank has excess reserves and another needs reserves, they trade overnight, and the rate they agree on is the federal funds rate. This rate is a primary policy lever for the central bank. The Fed sets a target range for the federal funds rate and uses open market operations—buying or selling government securities—to adjust the supply of reserves in the banking system so the market rate moves toward that target. The actual rate that materializes is the effective federal funds rate, which can drift within the target range depending on day-to-day conditions. It’s not the rate you’d pay on a car loan, which is determined by lenders based on credit risk and terms offered to consumers. It’s also not the rate charged by the Fed for discount window loans, which is a different facility for banks to borrow directly from the Fed. And it isn’t the rate used for international currency swaps, which are separate kinds of arrangements.

The federal funds rate is the interest rate at which depository institutions lend reserve balances to each other overnight in the federal funds market. Banks hold these reserves to meet regulatory requirements and to settle payments. When one bank has excess reserves and another needs reserves, they trade overnight, and the rate they agree on is the federal funds rate.

This rate is a primary policy lever for the central bank. The Fed sets a target range for the federal funds rate and uses open market operations—buying or selling government securities—to adjust the supply of reserves in the banking system so the market rate moves toward that target. The actual rate that materializes is the effective federal funds rate, which can drift within the target range depending on day-to-day conditions.

It’s not the rate you’d pay on a car loan, which is determined by lenders based on credit risk and terms offered to consumers. It’s also not the rate charged by the Fed for discount window loans, which is a different facility for banks to borrow directly from the Fed. And it isn’t the rate used for international currency swaps, which are separate kinds of arrangements.