Federal funds rate

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The federal funds rate is the interest rate at which depository institutions lend balances (federal funds) at the Federal Reserve to other depository institutions overnight.

Here is how the system works:

U.S. banks and thrift institutions are obliged by law to keep certain no-interest-bearing reserves with the Fed (or to keep an equal amount of vault cash, but this imposes risks and costs). The level of these reserves is determined by the outstanding assets and liabilities of each depositary institution, as well as by the Fed itself, but is typically 10% of the total value of the bank's demand accounts.
Assume that a particular U.S. depositary institution (Bank A) needs additional money in order to keep its reserve at the Fed at the legally required level. To this purpose, it will borrow the requisite funds from another bank (Bank B) that has a surplus in its Fed reserves. The interest rate that Bank A will pay to Bank B in return for borrowing the funds is negotiated between the two banks, and the weighted average of this rate across all banks is the effective Federal Funds Rate.

The nominal rate is a target set by the governors of the Federal Reserve, which they enforce primarily by open market operations (the buying and selling of bonds). When the media refer to the Federal Reserve "changing interest rates," this nominal rate is almost always meant. The target is generally a range, as the Federal Reserve cannot set an exact value through open market operations.

Another way banks can borrow funds to keep up their required reserves is by getting a loan from the Federal Reserve itself at the discount rate. These loans are very short term and rare, as they are subject to audit by the Fed, which is why overnight loans between institutions are preferred. Confusion between these two kinds of loans often leads to confusion between the federal funds rate and the discount rate - the rate at which the Fed lends to financial institutions. Another difference is that, while the Fed cannot set an exact federal funds rate, it can set a specific discount rate.