For purposes of monetary policy, the federal reserve has targeted the interest rate known as the

Now that you know about the Federal Reserve’s policy tools, let’s see how the Fed uses the tools to achieve its dual mandate—maximum employment and price stability.

How Expansionary Monetary Policy Works

Suppose the economy weakens and employment falls short of the Fed’s maximum employment goal. Meanwhile, the inflation rate is showing signs that it will fall below the target. The Federal Open Market Committee (FOMC) might decide to use expansionary monetary policy to provide stimulus for the economy. That is, the FOMC could lower its target range for the federal funds rate (FFR).

When doing so, the Fed would decrease its administered interest rates—interest on reserve balances (IORB), overnight reverse repurchase agreement (ON RRP) offering, and discount—accordingly.

Expansionary Monetary Policy Graph

This animated graph of expansionary monetary policy shows how a cut in the federal funds rate target triggers a decrease in the Fed’s administered rates, which results in a lower federal funds rate.

These actions by the Fed would transmit to other market interest rates and broader financial conditions. Here is how expansionary monetary policy translates into the economy:

• Lower interest rates decrease the cost of borrowing money, which encourages consumers to increase spending on goods and services and businesses to invest in new equipment.
• The increase in consumption spending by consumers and investment spending by businesses increases the overall demand for goods and services in the economy.
• With increased production, businesses are likely to hire additional employees and spend more on other resources.
• As these increases in spending ripple through the economy, unemployment decreases, moving the economy toward maximum employment.

So, the Fed’s monetary policy tools can be effective for moving the economy back toward the maximum employment component of the dual mandate when the economy is weak.

How Contractionary Monetary Policy Works

Suppose that inflation has exceeded 2 percent for some time and the Fed recognizes that individuals are starting to expect high and rising inflation going forward. In this situation, the FOMC might decide to use contractionary monetary policy to bring actual and expected inflation back toward its target, to maintain price stability.

To do this, the FOMC could raise its target range for the federal funds rate (FFR) and increase the administered rates—interest on reserve balances (IORB) rate, overnight reverse repurchase agreement (ON RRP) offering rate, and discount rate—accordingly.

Contractionary Monetary Policy Graph

This animated graph of contractionary monetary policy shows how an increase in the federal funds rate target triggers an increase in the Fed’s administered rates, which results in a higher federal funds rate.

Here is how contractionary policy actions by the Fed would transmit to other market interest rates and broader financial conditions.

• Higher interest rates increase the cost of borrowing money, which discourages consumers from spending on some goods and services and reduces businesses’ investment in new equipment.
• The decrease in consumption spending by consumers and in investment spending by businesses decreases the overall demand for goods and services in the economy.
• With decreased production, businesses are less likely to hire additional employees and spend more on other resources.
• As these decreases in spending ripple through the economy, inflationary pressures would diminish and the inflation rate would fall back toward 2 percent.

Note that the goal of contractionary monetary policy is to decrease the rate of demand for goods and services, not to stop it. So, higher interest rates through contractionary policy can be used to dampen inflation and move the economy back to the price stability component of the dual mandate.

What Is the Federal Funds Rate?

The term federal funds rate refers to the target interest rate set by the Federal Open Market Committee (FOMC). This target is the rate at which commercial banks borrow and lend their excess reserves to each other overnight. The FOMC, which is the policymaking body of the Federal Reserve System, meets eight times a year to set the target federal funds rate, which is part of its monetary policy. This is used to help promote economic growth.

Key Takeaways

• The federal funds rate is the target interest rate set by the FOMC.
• This is the rate at which commercial banks borrow and lend their excess reserves to each other overnight.
• The FOMC sets a target federal funds rate eight times a year, based on prevailing economic conditions.
• The federal funds rate can influence short-term rates on consumer loans and credit cards.
• Investors keep an eye out on the federal funds rate as well because it has an impact on the stock market.

Understanding the Federal Funds Rate

The federal funds rate refers to the interest rate that banks charge other institutions for lending excess cash to them from their reserve balances on an overnight basis. By law, banks must maintain a reserve equal to a certain percentage of their deposits in an account at a Federal Reserve bank. The amount of money a bank must keep in its Fed account is known as a reserve requirement and is based on a percentage of the bank's total deposits.

Financial institutions are required to maintain interest-bearing accounts at Federal Reserve banks to ensure they have enough money to cover depositors' withdrawals and other obligations. Any money in their reserve that exceeds the required level is available for lending to other banks that might have a shortfall.

The end-of-the-day balances in the bank's account averaged over two-week reserve maintenance periods are used to determine whether it meets its reserve requirements. If a bank expects to have end-of-the-day balances greater than what's required, it can lend the excess to an institution that anticipates a shortfall in its balances. The interest rate the lending bank can charge is the federal funds rate, or fed funds rate.

The FOMC makes its decisions about rate adjustments based on key economic indicators that may show signs of inflation, recession, or other issues that can affect sustainable economic growth. The indicators can include measures like the core inflation rate and the durable goods orders report.

The target for the federal funds rate has varied widely over the years in response to the prevailing economic conditions. It was set as high as 20% in the early 1980s in response to inflation. With the coming of the Great Recession of 2007 to 2009, the rate was slashed to a record low target of 0% to 0.25% in an attempt to encourage growth.

3%-3.25%

The federal funds rate target range as set by the FOMC at its September 2022 meeting. The committee decided to raise the rate by 75 basis points from the 2.25%-2.5% target set in July.

Special Considerations

The FOMC cannot force banks to charge the exact federal funds rate. Rather, the FOMC sets a target rate as a guidepost. The actual interest rate a lending bank will charge is determined through negotiations between the two banks. The weighted average of interest rates across all transactions of this type is known as the effective federal funds rate.

While the FOMC can't mandate a particular federal funds rate, the Federal Reserve System can adjust the money supply so that interest rates will move toward the target rate. By increasing the amount of money in the system it can cause interest rates to fall. Conversely, by decreasing the money supply it can make interest rates rise.

Besides the federal funds rate, the Federal Reserve also sets a discount rate, which is the interest rate the Fed charges banks that borrow from it directly. This rate tends to be higher than the target fed funds rate, partly to encourage banks to borrow from other banks at the, lower, federal funds rate.

Impact of the Federal Funds Rate

The federal funds rate is one of the most important interest rates in the U.S. economy. That's because it affects monetary and financial conditions, which in turn have a bearing on critical aspects of the broader economy including employment, growth, and inflation.

The rate also influences short-term interest rates, albeit indirectly, for everything from home and auto loans to credit cards, as lenders often set their rates based on the prime lending rate. The prime rate is the rate banks charge their most creditworthy borrowers—a rate that is also influenced by the federal funds rate.

Investors keep a close watch on the federal funds rate. The stock market typically reacts very strongly to changes in the target rate. For example, a small decline in the rate can prompt the market to leap higher as the borrowing costs for companies get lower. Many stock analysts pay particular attention to statements by members of the FOMC to try to get a sense of where the target rate may be headed.

How Does the Federal Funds Rate Work?

The federal funds rate is the interest rate that banks charge each other to borrow or lend excess reserves overnight. Law requires that banks must have a minimum reserve level in proportion to their deposits. This reserve requirement is held at a Federal Reserve Bank. When a bank has excess reserve requirements, it may lend these funds overnight to other banks that have realized a reserve deficit.

How Is the Federal Funds Rate Determined?

It is customary for the Federal Open Market Committee (FOMC) to meet eight times annually to determine the federal funds rate. These rates are influenced by economic indicators, such as the core inflation rate and the durable goods orders report, which provide signals about the economic health of the country.

What Is the Difference Between the Federal Funds and Regular Interest Rates?

Both the federal funds rate and interest rates are some of the most important financial indicators in the U.S. The chief distinction is that the federal funds rate sets the range that banks will lend or borrow to each other overnight. Because this impacts borrowing costs and financial conditions, stock markets are typically sensitive to changes in these rates. The federal funds rate also indirectly affects short-term interest rates. Conversely, interest rates, which are set by the Federal Reserve, determine the rate that it costs for banks to borrow.

Correction—July 26, 2022: This article was corrected from a previous version that stated financial institutions are required to maintain non-interest-bearing accounts at Federal Reserve banks. In 2008, the Federal Reserve was authorized by Congress to pay interest on balances that banks hold at the Fed.

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