What Are Federal Funds?
Let me explain federal funds to you directly: they're often called fed funds, and they represent excess reserves that commercial banks and other financial institutions deposit at regional Federal Reserve banks. You should know that these funds can then be lent to other market participants who don't have enough cash on hand to meet their lending and reserve needs. These loans are unsecured and come at a relatively low interest rate, which we call the federal funds rate or overnight rate, since most of these loans are for that short overnight period.
Key Takeaways
- Federal funds refer to excess reserves held by financial institutions, over and above the mandated reserve requirements of the central bank.
- Banks will borrow or lend their excess funds to each other on an overnight basis, as some banks find themselves with too much reserves and others with too little.
- The federal funds rate is a target set by the central bank, but the actual market rate for federal fund reserves is determined by this overnight inter-bank lending market.
Understanding Federal Funds
I want you to understand how fed funds work in practice: they help commercial banks meet their daily reserve requirements, which is the amount of money banks must maintain at their regional Federal Reserve. These reserve requirements are based on the volume of customer deposits each bank holds. Excess, or secondary, reserves are cash amounts held by a bank or financial institution beyond what's required by regulators, creditors, or internal controls. For commercial banks, we measure excess reserves against standard reserve requirement amounts set by central banking authorities. These required reserve ratios set the minimum liquid deposits, like cash, that must be in reserve at a bank; anything more is considered excess.
The Federal Reserve Bank sets a target rate or range for the fed funds rate, and it adjusts this periodically based on economic and monetary conditions.
Overnight Markets
Consider the overnight markets: the fed funds market operates in the United States and runs parallel to the offshore eurodollar deposit market. Eurodollars are also traded overnight, and their interest rate is virtually identical to the fed funds rate, but the transactions must be booked outside of the United States. Multinational banks often use branches in places like the Caribbean or Panama for these accounts, even if the transactions are executed in U.S. trading rooms. Both are wholesale markets, with transactions ranging from $2 million to well over $1 billion.
The Fed Funds Rates
Here's how the Federal Reserve manages this: it uses open market operations to control the supply of money in the economy and adjust short-term interest rates. This involves the Fed buying or selling some of the government bonds and bills it has issued, which increases or decreases the money supply and thus lowers or raises short-term interest rates. These open market operations are carried out by the Federal Reserve Bank of New York.
The federal funds rate, or fed funds rate, is one of the most important interest rates for the U.S. economy, as it affects broad economic conditions in the country, including inflation, growth, and employment. This rate is set in U.S. dollars and is typically charged on overnight loans. Essentially, the fed funds rate is the effective interest rate at which commercial banks lend reserves to one another on an overnight basis.
The federal funds rate is closely related to short-term interest rates in the broader market, so these transactions directly impact eurodollar and SOFR rates as well. The Federal Reserve announces the effective fed funds rate at the end of each trading day, which is the weighted average rate for all transactions in the market that day.
Market Participants
You should know who participates in the fed funds market: it includes U.S. commercial banks, U.S. branches of foreign banks, savings and loan organizations, and government-sponsored enterprises such as the Federal National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage Association (Freddie Mac), as well as securities firms and agencies of the federal government.
Other articles for you
An unqualified opinion is an auditor's clean bill of health for a company's financial statements, confirming they are fairly presented and GAAP-compliant without exceptions.
Financial risk encompasses the potential for monetary loss affecting individuals, businesses, and governments through various types like credit, liquidity, and operational risks.
Capitalization in accounting involves recording costs as assets to spread them over time, and it also describes a company's mix of debt and equity funding.
Out-of-the-money options lack intrinsic value but hold potential extrinsic value based on time and market volatility.
A world fund is a mutual fund investing in securities from multiple countries including the US to diversify and minimize risks.
Negative amortization occurs when unpaid interest on a loan is added to the principal balance, causing it to increase instead of decrease.
Recharacterization allows treating an IRA contribution as if made to a different IRA type, with Roth conversions now irrevocable.
HENRYs are high-income individuals earning $250,000 to $500,000 annually who struggle to build wealth due to high expenses.
High-yield investment programs (HYIPs) are fraudulent Ponzi schemes promising unrealistically high returns to deceive investors.
A beneficial owner is someone who enjoys the benefits of an asset's ownership even if the legal title is held by another party.