What Is the Federal Funds Rate? How the Fed Rate Is Set

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The federal funds rate is the interest rate at which depository institutions, mainly banks, lend reserve balances to one another overnight without collateral. When people say “the fed rate” or “Fed interest rates,” they usually mean the target range for this rate, which the Federal Open Market Committee (FOMC) of the Federal Reserve announces after each policy meeting. The rate that actually prevails in the market is the effective federal funds rate, and the Fed’s tools are designed to keep it inside that target range.

The Fed does not set the rate on your mortgage, credit card or savings account. It sets a target for one overnight interbank rate, and that target shapes what lenders pay for short-term money, which in turn moves most other short-term rates.

What the Federal Funds Rate Measures

Banks hold reserve balances in accounts at Federal Reserve Banks and use them to settle payments with each other, meet customer withdrawals and satisfy regulatory liquidity needs. At the end of a day, one institution may hold more reserves than it wants while another holds fewer. The first can lend the surplus to the second until the next business day, and the interest rate negotiated on that loan is a federal funds rate.

Three features define these loans:

• Overnight term. Most fed funds trades mature the next business day.
• Unsecured. The borrower posts no collateral, which distinguishes fed funds from repurchase agreements (repos).
• Restricted participants. Only eligible institutions, such as commercial banks, savings institutions, credit unions, U.S. branches of foreign banks and government-sponsored enterprises like the Federal Home Loan Banks, trade in this market.

Each trade is negotiated between the two parties, so rates vary slightly from loan to loan, and the Fed does not dictate the price of any individual trade. What it announces is the federal funds target range, for example a hypothetical range of 3.75% to 4.00%, typically 25 basis points (0.25 percentage point) wide. The FOMC announced a single target number until December 2008, when it switched to a range.

The effective federal funds rate (EFFR) reports where trading actually happened. The New York Fed calculates it from transaction data that banks report and publishes it each morning for the previous business day. Under normal conditions the EFFR sits inside the target range, often a few basis points above the bottom.

Who Sets the Target: The FOMC

The FOMC is the Federal Reserve’s monetary policy committee. Its 12 voting members are the seven members of the Board of Governors, the president of the Federal Reserve Bank of New York and four of the other 11 regional Reserve Bank presidents, who vote on a rotating basis. All 12 presidents take part in discussions.

The committee holds eight scheduled meetings a year, about every six weeks, and can meet in between when conditions require it. Each meeting ends with a statement giving the target range and explaining the decision. Four meetings also include a Summary of Economic Projections, whose rate forecasts are often shown as the “dot plot.”

Decisions are guided by the Fed’s dual mandate from Congress: maximum employment and stable prices, which the Fed defines as 2% inflation over the longer run on the personal consumption expenditures (PCE) price index. The committee weighs employment, wage growth, spending, business investment, financial conditions and inflation measures such as the Consumer Price Index and core inflation, which excludes food and energy.

Why the Fed Raises or Lowers the Rate

• Raising the target makes short-term borrowing more expensive, which tends to slow spending and borrowing, encourage saving and ease pressure on prices. The Fed raises when inflation runs too high or the economy is overheating.
• Lowering the target makes credit cheaper, supporting spending, hiring and investment. The Fed cuts when growth is weakening, unemployment is rising or inflation is comfortably under control.
• Holding steady signals that the committee views current policy as appropriate for the outlook.

Moves of 25 basis points are the standard increment. The committee has moved by 50 or 75 basis points, or more in emergencies, when it wanted a faster effect.

How the Fed Keeps the Rate in Its Target Range

Announcing a range does not make banks trade inside it. The Fed has to make trading outside the range unattractive, and its method changed after 2008.

Before 2008: scarce reserves. Banks held only slightly more reserves than required, so the overnight rate was sensitive to small changes in supply. The New York Fed’s trading desk bought or sold Treasury securities daily to add or drain reserves and push the rate toward the target. Reserve requirements, a percentage of certain deposits banks had to hold as reserves, created predictable demand for reserves.

Since 2008: ample reserves. Large-scale asset purchases left the banking system with far more reserves than it needs day to day. In this setting, small open market operations barely move the overnight rate, so the Fed relies on administered rates, rates it sets directly:

• Interest on reserve balances (IORB). The Fed pays interest on reserves banks hold with it, so a bank has little reason to lend reserves overnight for much less. IORB is the Fed’s main lever and is usually set within the target range.
• Overnight reverse repurchase agreement (ON RRP) facility. Money market funds and certain other institutions can’t earn IORB, but they can lend cash to the Fed overnight at the ON RRP rate, typically set at the bottom of the target range. This puts a floor under short-term rates for a broader set of lenders.
• Discount rate (primary credit rate). Banks can borrow directly from the Fed’s discount window, usually at the top of the target range, so they have little reason to pay much more in the market. This helps cap the effective rate.

When the FOMC changes its target range, it adjusts these administered rates at the same time, and the effective rate follows. Reserve requirement ratios have been zero since March 26, 2020, so requirements no longer drive demand in this market. Banks still hold large reserve balances for payments, liquidity rules and risk management.

Calculating the Effective Rate and the Cost of a Fed Funds Loan

The effective federal funds rate is a volume-weighted median. The New York Fed ranks each day’s overnight trades by rate, weights each trade by its dollar size, and takes the rate at which half the volume traded higher and half lower. A median limits the influence of a few unusually high- or low-priced trades.

Hypothetical example: a single overnight loan. Bank A has $50 million in reserves it doesn’t need tonight. Bank B expects to be short and agrees to borrow the $50 million at 4.00% until the next business day. Fed funds interest is conventionally calculated on an actual/360 day-count basis:

Interest = Principal × Rate × (Days ÷ 360) Interest = $50,000,000 × 0.04 × (1 ÷ 360) = $5,555.56

Bank B repays $50,005,555.56 the next morning. Over a weekend, a Friday loan maturing Monday runs three days, so the interest would be three times as large, about $16,666.67, under the same assumptions.

Hypothetical example: reading the effective rate. Suppose a day’s trades total $100 billion: $30 billion at 3.82%, $45 billion at 3.83% and $25 billion at 3.85%. Sorting by rate, the 50% volume point falls within the $45 billion block at 3.83% (cumulative volume runs from $30 billion to $75 billion there), so the effective rate is 3.83%. With a target range of 3.75% to 4.00%, that sits eight basis points above the floor.

How Changes Pass Through to Other Rates

The fed funds target affects the rest of the economy through a chain of prices and expectations:

• Prime rate. By long-standing convention, the widely quoted prime rate equals the top of the fed funds target range plus 3 percentage points, so it typically moves the same day as an FOMC change.
• Credit cards and home equity lines. Many variable-rate cards and HELOCs are priced as prime plus a margin, so their rates reset within a billing cycle or two of a Fed move.
• Savings accounts and CDs. Deposit rates generally follow the target up and down, though banks decide how much and how fast to pass changes on.
• Auto and personal loans. Pricing on new loans tracks lenders’ short-term funding costs.
• Mortgages. Thirty-year fixed rates follow longer-term Treasury yields, especially the 10-year, and what markets expect the Fed to do over many years, so they can move before a Fed decision or even in the opposite direction. Existing fixed-rate mortgages don’t change.
• The dollar. Higher U.S. rates relative to other countries tend to attract foreign capital and can strengthen the dollar, which affects import prices and exporters’ competitiveness.
• Stocks and bonds. Higher rates raise companies’ borrowing costs and the rate used to discount future earnings, which can weigh on valuations. Indexes such as the S&P 500 often react sharply to FOMC surprises.
• Government borrowing. Treasury bill yields follow the fed funds rate closely, so rate levels affect federal interest costs.

Expectations matter as much as the decision itself. Markets price the likely path of rates in advance, so the committee’s statement, projections and the chair’s press conference can move markets as much as the rate change.

Notable Highs and Lows

The target has ranged widely. Under Chair Paul Volcker, the Fed pushed the rate to about 20% in the early 1980s to break double-digit inflation, which helped bring inflation down at the cost of a severe recession. In December 2008, during the financial crisis, the FOMC cut the target to 0% to 0.25% and held it there for seven years. It returned to that range in March 2020 at the start of the pandemic, then began raising rates rapidly in March 2022 as inflation climbed to four-decade highs, including several 75-basis-point increases that year.

Fed Funds Rate vs. Other Interest Rates

Several rates are confused with the fed funds rate:

• Discount rate. This is the rate the Fed charges banks that borrow directly at the discount window. The fed funds rate is what banks charge each other.
• Interest on reserve balances. This is what the Fed pays banks on reserves. The Fed sets it, while the fed funds rate comes from trading between institutions.
• SOFR. The Secured Overnight Financing Rate measures overnight borrowing backed by Treasury collateral in the much larger repo market. It differs from the unsecured fed funds rate and has replaced LIBOR as the benchmark for many loans and derivatives.
• Prime rate. Commercial banks set it, but in practice it is anchored to the fed funds target.
• Consumer loan rates. These add the lender’s funding cost, the borrower’s credit risk, the loan term and the lender’s margin, so they are always higher than the fed funds rate.

Limitations of the Federal Funds Rate

• Policy acts with lags. Rate changes can take many months to affect hiring, spending and inflation, so the Fed must act on forecasts that may prove wrong.
• It doesn’t control long-term rates. Mortgage and corporate bond yields also depend on inflation expectations, term premiums and global demand for Treasuries.
• The zero lower bound. Near zero the Fed can’t cut much further. In 2008 and 2020 it turned to asset purchases (quantitative easing) and forward guidance.
• A thinner market. With reserves abundant, banks borrow less overnight and the Federal Home Loan Banks supply much of the lending, so the rate works more as a policy signal than as a gauge of banks’ day-to-day funding needs.
• Uneven effects. Variable-rate borrowers feel changes immediately, homeowners with fixed-rate mortgages may barely notice, and savers benefit from higher rates that hurt borrowers.
• It can’t fix supply problems. Higher rates reduce demand but can’t produce more goods when prices rise because of supply shortages, energy shocks or disruptions to the factors of production.

The Bottom Line

Borrowers with credit cards, home equity lines and other variable-rate debt feel fed funds changes fastest, while existing fixed-rate mortgages stay the same. Savers usually see deposit rates follow the target, though banks control how much and how quickly they pass changes on. Anyone watching rates should track the FOMC statement, projections and the chair's press conference, since expectations can move markets as much as the decision itself.