Federal Funds Rate Definition: The federal funds rate is the interest rate at which US banks lend reserve balances to each other overnight. The Federal Reserve’s policy committee sets a target range for it, usually 0.25 percentage points wide, and uses administered rates to keep trading inside that band. As the base cost of dollar money, it anchors the prime rate, short-term Treasury yields and the pricing of loans across the economy.
What Is the Federal Funds Rate?
Banks end every day with either more cash at the central bank than they need or less. Those deposits are called reserves, and banks with a surplus lend them to banks with a shortfall for one night. The interest charged on those loans is the federal funds rate.
That modest overnight market matters because the Federal Reserve chooses where the rate should be. When the Fed wants to cool the economy, it raises the target, and borrowing becomes more expensive everywhere. When it wants to support growth, it cuts. Headlines such as “the Fed raised rates” refer to this number.
Knowing the definition is enough to follow the news. Trading around the rate requires one more step: understanding how the Fed actually holds it in place and how markets forecast its next move.
How Does the Federal Funds Rate Work?
Since December 2008 the Fed has set a range rather than a single number. It keeps the market rate inside the range with two administered rates. Interest on reserve balances, paid to banks on money parked at the Fed, sets a level below which few banks will lend. The overnight reverse repo rate, offered to money market funds, puts a floor under the wider market.
Before 2008 the system worked differently. Reserves were scarce, so the New York Fed hit its target by buying or selling Treasury bills each day to add or drain cash. The Fed began paying interest on reserves in October 2008, and that tool let it keep control of the rate once quantitative easing flooded banks with cash.
The rate then passes through to other interest rates. By convention, US banks set their prime lending rate at the top of the target range plus 3 points, so a 5.25% to 5.50% range means a prime rate of 8.5%. Credit cards, business loans and many adjustable mortgages are priced as a margin over prime.
Traders forecast the rate with 30-day fed funds futures, which trade at a price of 100 minus the expected average rate. Suppose the effective rate is 5.00% and next month’s contract trades at 94.75, which implies 5.25%. The market is pricing a 0.25 point hike with near certainty, and a hold at the meeting would send the contract up and the dollar down.
Federal Funds Rate vs. Discount Rate
| Federal Funds Rate | Discount Rate | |
|---|---|---|
| Who lends | Banks to other banks | The Fed directly to banks |
| How it is set | Market rate steered into a target range | Set by the Fed at a fixed level |
| Typical level | Inside the target range | At or above the top of the target range |
| Main purpose | Signals the stance of monetary policy | Backstop funding through the discount window |
Why Is the Federal Funds Rate Important for Traders?
The federal funds rate is the anchor for pricing almost every dollar asset. Cash yields rise and fall with it, so it sets the hurdle that stocks, bonds and crypto have to beat. When the range rose from 0% to 0.25% in March 2022 to 5.25% to 5.50% in July 2023, money market funds suddenly paid more than 5%, and investors pulled money out of riskier assets to earn it.
Currency traders watch it through the gap with other central banks. A higher US rate relative to Japan or Europe raises the return on holding dollars, which fuels carry trades and supports the dollar until the gap starts to narrow.
The rate has limits as a signal and as a tool. It can drift outside the range when funding markets are stressed, as on 17 September 2019, when a squeeze in repo markets pushed the effective rate to 2.30%, above the 2.25% top of the range. Rate changes also take a year or more to reach hiring and prices, so the level you see today reflects the Fed’s forecast of the economy, not the economy itself.
Key Takeaways
- The federal funds rate is the overnight rate US banks charge each other on reserve balances, and it is the Fed’s main policy rate.
- The Fed sets a target range and holds the market rate inside it with the interest it pays on reserves and on reverse repos.
- Changes pass through to the prime rate, Treasury bills, loans and deposits, which is why the rate anchors pricing across dollar markets.
- Fed funds futures, priced at 100 minus the expected rate, show what the market expects before each policy meeting.
- The rate works with long lags and can slip outside its range during funding stress, so it guides markets rather than controlling them precisely.
What is the difference between the target range and the effective federal funds rate?
The target range is the band the FOMC announces, such as 5.25% to 5.50%. The effective rate is the actual volume-weighted median of overnight trades, published each morning by the New York Fed, and it normally sits inside the range.
How does the federal funds rate affect mortgage rates?
It affects them indirectly. Fixed mortgage rates follow the 10-year Treasury yield more closely than the overnight rate, so a Fed cut can leave mortgage rates unchanged if investors expect higher inflation or more government borrowing.
What was the highest federal funds rate in history?
The effective rate briefly exceeded 20% at the turn of 1980 and 1981, when Paul Volcker's Fed used extreme rates to break double-digit inflation. The lowest setting is the 0% to 0.25% range used in 2008 to 2015 and again from March 2020 to March 2022.
Does the federal funds rate affect crypto prices?
There is no direct link, but crypto has tended to trade like other risk assets when rates move. Higher rates raise the return on cash and reduce leverage in the system, which weighed on Bitcoin during the 2022 hiking cycle.
