Fed Funds and How the Funds Market Works

Fed Funds and How the Funds Market Works

The Secret to How the Fed Controls Interest Rates

By Kimberly Amadeo Updated April 11, 2022  Reviewed By Eric Estevez  Fact Checked By David Rubin

Federal funds are reserves held in a bank's Federal Reserve account. If a bank holds more than the reserve requirement at the end of each day, it can lend it to a bank that doesn't have enough. Most fed funds transactions are overnight and collateral-free. Since there is no collateral, both banks have high levels of mutual confidence. The fed funds transaction, although it behaves as a loan, is technically a sale. The "lending" bank charges a small fee. This is the federal funds effective rate. The Federal Reserve uses this rate to control the nation's interest rates.1

The Federal Reserve Open Market Committee (FOMC) sets the rate's target at its regular meetings. This rate is called the "fed funds rate."

The Fed uses open market operations to encourage banks to meet this target. It buys securities, replacing them with credit, and giving banks more fed funds to lend. When it wants the effective rate to rise, it removes credit from the banks, replacing it with securities.

A high fed funds rate means interest rates will be high as a result. A low fed funds rate encourages lending because interest rates are lower.2

How the Fed Funds Market Works

At the end of each day, banks with reserves greater than the reserve requirement lend the excess to banks that don't have enough on hand to meet the requirement. The reserve requirement is a percentage of the bank's deposits.3

NOTE:  A bank must have enough in its vaults or at a Federal Reserve Bank each night to meet the reserve requirement. Banks that don't have enough borrow fed funds from banks that have more than the reserve requirement.

Banks can also meet the overnight requirement by borrowing from the Federal Reserve's discount window.4 That interest rate, known as the federal "discount rate," is usually higher than the fed funds rate. That encourages banks to borrow fed funds from each other.5

On March 15, 2020, the Fed announced it had reduced the reserve requirement ratio to zero effective March 26, 2020.3 It did so to encourage banks to lend out all of their funds during the COVID-19 coronavirus pandemic.

Fed Funds Trends

The fed funds market began shrinking after the 2008 financial crisis. In 2007, banks lent $200 billion. By 2012, it was only $60 billion.6 What happened?

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