Sometimes during the day-to-day transactions, banks need to borrow money for a very short duration say even for a single day due to the transfer of funds and banking transactions. For this, banks borrow money from each other to fulfill their short-term fund needs and interest is charged on such borrowing. FinanceShed has come up with a detailed analysis of these federal loans and the Federal Funds Rate.
What is the Federal Fund Rate?
The federal funds rate is the interest rate that is charged by banks for overnight loans given to each other to meet reserve requirements out of the reserve balances available to other banks. All the banks are required to meet the minimum reserve requirements and if they are not able to keep the required reserve, the bank can borrow money from the Federal Reserve or from other banks. The amount that exceeds the minimum requirement can be given as a federal loan to other banks. These rates are different from the discount rates of banks.
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How Do Federal Fund Rates work?
When, at the end of the day, the bank is short of cash or does not have the minimum required reserve requirement, they can borrow from a bank with extra money. For this, banks charge each other for overnight loans to meet these reserve balances. The amount so borrowed is called Federal Fund and the rate of interest charged by the banks is called Federal Funds Rate.
To decide the rates to be charged by banks, the Federal Open Market Committee (FMOC) sets a target in their meeting. The rates are decided to keep in mind the open market operations. The committee sometimes gives the banks more reserves than they need by purchasing securities in order to lower the interest rates. The committee sells the securities so purchased when they want the rates to be higher and removes funds from the bank’s balance sheet.
Also, it is not mandatory for banks to charge the rate of interest as suggested by the FMOC but, the FMOC can force the banks to lower the rates in order to have smooth borrowing between the banks.
How It Is Useful For Economy
The federal fund is a driving force in defining the monetary and financial conditions in the economy as the rates charged by banks on the federal fund has a huge impact on the economy as a whole. There are chances of an increase in rates of Federal fund reserve in the future period that implies that it will successfully raise short-term interest rates but have a limited impact on long-term interest rates looking at the past aspects. It can also have a huge impact on other economic aspects such as employment, growth, and inflation.
The changes in Federal Rates also affect the Prime rate, lines of credit and mortgages. Also, these rates affect the stock market and stock prices so the Investors keep a close watch on the federal funds rate. The Fed also sets discount rates- the rates charged by the Fed on lending to the banks that are generally higher than the federal rates.
Lastly, the Federal Funds Rate affects the economy as a whole including its impact on the prices of the services and products, job and wages rates, credit card rates, auto loan, mortgages, credit card and what not. Some Highest Paying Jobs in The U.S might also get affected. Thus, be it an investor or a common resident, everyone has an eye on the rates decided by the Fed as Federal Rates as they can have larger implications on the economy at a global level.