The Fed Funds Rate is directly involved in how a bank operates on a daily basis.
Who sets the Fed Funds Rate?
When you hear about the Fed Funds Rate, you will most likely hear about the FOMC known as the Federal Open Market Committee and the Chair of the Federal Reserve. Currently, as of February 2018 the Chair of the Federal Reserve is Jerome Powell. Also, when you hear Jerome Powell you will usually hear the term interest rate in the same sentence. It is his duty to assess the economy and make extremely important decisions to ultimately keep the economy moving in the right direction. This is where the Fed Funds Rate comes into play. The FOMC schedules eight meetings per year and determines the direction of monetary policy. The FOMC includes 12 total members, 7 from the Board of Governors and 5 of the Reserve bank presidents. We can touch on the make up of the FOMC in another post, but to give you an idea of how many members weigh in on these decisions, I wanted to include that for you.
Bank Operations tied to Fed Funds Rate
To understand why the Fed Funds Rate is important, we must first look at how a bank operates. So imagine your typical bank, lets say Bank of America. You may have an account there or two, say a checking and savings account. This is where you keep your money instead of under your mattress. Well there are also thousands of other people who are making withdrawals and deposits daily from that same bank. You deposit your money; the bank will loan that money out to other customers who are making withdrawals. Now don’t get me wrong, that money you deposited is still in your checking or savings account, but for a bank to operate on a daily basis they are loaning out that money. There needs to be a way that the bank can always have enough cash to be able to fulfill these orders. The bank will hold a percentage of deposited cash, so they can meet a certain requirement set by the Federal Reserve. The requirement set by the Federal Reserve is called the Reserve Requirement and this is set at roughly 10%. This requirement forces the bank to hold enough capital to serve every day banking needs.
Now sometimes there is an issue the banks will come across and I’m sure you can probably see where this is going. The bank may have had more money withdrawn than deposited on a particular day and at the end of the banking day they don’t have the reserve requirement of 10%. Now the funds the bank is required to hold isn’t generally held in their vault physically at the bank. They will store this money at the federal reserve. This money is called Federal Funds.
If a bank does not have enough federal funds at the end of the day, they need to somehow be loaned money to meet this 10% required of Federal Funds. What will happen is they will ask another bank to loan them some cash, so they can meet the requirement of 10%. They will need to borrow from a bank that has excess federal funds on hand. Now a bank isn’t just going to hand over its excess federal funds for free. They aren’t that nice or close of friends. The bank with excess federal funds will charge an interest rate for the funds they fork over. This is called the Federal Funds Rate.
The Fed Funds Rate is the interest rate at which depository institutions lend excess federal funds to other depository institutions overnight.
Now the Fed Funds Rate is very important because it will be what is set by the FOMC as it is a major indication of how the economy is doing. It will set the tone for many different interest rates in the economy. Think credit card interest rates, auto loans, mortgage loans, student loans, etc..
Keep in mind, the Fed Funds Rate is an interest rate that is set for banks loaning money on an overnight basis so other banks can meet their reserve requirements. There is another rate to pay attention to and that is LIBOR. The difference here is that LIBOR will be interest rates between banks but not on an overnight basis. Usually 3, 6, 9, 12 months.
The impacts of the movement of the Fed Funds Rate is crucial to the whole economy. It will have impacts on inflation, consumer spending and virtually every aspect of the economy.