‘Federal Funds Rate’ – explained in simple terms

On September 18, 2007, the US Federal Reserve (the “Fed”) cut its target Fed funds rate by 50 basis points (half-of-a-percentage point) to 4.75%, giving a boost to stocks markets worldwide.

The Fed also cut its discount rate by another 50 basis points, bringing it down to 5.25%.

What is the federal funds rate?

The funds rate is the interest rate that banks charge each other for overnight loans of federal funds, which are bank reserves at the US Federal Reserve System. Reserves are held at the Fed to meet reserve requirements of banks. Banks with excess reserve requirements can lend to institutions with deficiencies. These loans are usually made for 1 day only, that is, “overnight,” and the interest rate at which these transactions are done is called the “federal funds rate.”

How does it affect the economy?

Lower interest rates stimulate economic activity by lowering the cost of borrowing, making it easier for consumers and businesses to buy and build. Conversely, higher interest rates slow the economy down by increasing the cost of borrowing.

How exactly does it affect consumers?

The rate influences the amount of interest that financial institutions charge for various types of debt, such as credit cards, home equity, lines of credit, and auto loans. In the US, the rate cut is expected to help beleaguered home borrowers who are set to see monthly mortgage payments rise later this year.

What is the difference between the funds rate and the discount rate?

While the funds rate is the overnight lending rate among banks, the discount rate is the interest rate that banks pay to borrow directly from the US Federal Reserve. These loans are very short term and rare and are subject to audit by the Fed. The discount rate is usually higher than the federal funds rate. (See Fed statement below; the discount rate has been reduced to 5.25% but is still higher than the reduced 4.75% funds rate.)

Why do banks prefer to borrow from each other and not from the Fed?

Banks prefer borrowing funds from other banks, even at a higher interest rate, rather than directly from the Fed because this might suggest problems with the credit-worthiness or solvency of the bank.

The official statement from the Federal Reserve:

The Federal Open Market Committee decided today to lower its target for the federal funds rate 50 basis points to 4-3/4 percent.

Economic growth was moderate during the first half of the year, but the tightening of credit conditions has the potential to intensify the housing correction and to restrain economic growth more generally.  Today’s action is intended to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and to promote moderate growth over time.

Readings on core inflation have improved modestly this year.  However, the Committee judges that some inflation risks remain, and it will continue to monitor inflation developments carefully.

Developments in financial markets since the Committee’s last regular meeting have increased the uncertainty surrounding the economic outlook.  The Committee will continue to assess the effects of these and other developments on economic prospects and will act as needed to foster price stability and sustainable economic growth.

In a related action, the Board of Governors unanimously approved a 50-basis-point decrease in the discount rate to 5-1/4 percent.