Understanding the Federal Funds Rate

The Federal Reserve Act mandates the Federal Reserve to promote the goals of maximum employment and price stability. And, it utilizes various monetary policy tools to achieve the same. And, that helps keep the economy in good health.

So, this is how it works. Depository institutions hold reserve balances with Federal Reserve Banks. Not all depository institutions run in surplus. Some may require liquidity. So, those depository institutions that require liquidity borrow from other depository institutions that run in surplus at a rate, federal funds rate.

Though it is the market that determines what the appropriate federal funds rate should be in a transaction. But, the Federal Open Market Committee (FOMC) can influence it through Open Market Operations. It sets a target range for a federal funds rate.

What could be the target range for a federal funds rate is largely determined by the state of the economy. If the FOMC believes that the economy is running hot and inflation is rising then it can get rid of excess liquidity by increasing the target range. On the other hand, it may opt to provide surplus liquidity if the economy isn’t performing well.

So, when the Federal Reserve has to get rid of excess liquidity, it sells Government Bonds. This, in effect, would raise the federal funds rate to the target range since the participating institutions would have less liquidity to lend.

It buys Government bonds and increases liquidity which would ultimately bring the federal funds rate down.

Before coming to a decision on what the target federal funds rate should be, Federal Open Market Committee considers various indicators to gauge the direction of the economy. It may seem that it is required only to facilitate transactions between depository institutions. But, there is more to it. The federal funds rate acts as a base for lending activity in the economy. It influences the interest rates between numerous other transactions which happen between numerous market participants.

At the time of writing, the target range of the federal funds rate is 4.50 to 4.75%. Federal Open Market Committee (FOMC) meets eight times a year. Here is the complete schedule for the year 2023:

Jan/Feb    31-1

Mar          21-22

May         2-3

June         13-14

July          25-26

Sep          19-20

Oct/Nov   31-1

Dec          12-13

It would provide a Summary of Economic Projections in March, June, September, and December meetings.

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