ON1010 Research Guide

Federal Funds Rate Explained

What it is, how the Fed sets it, and why it’s the single most important number in the economy.

The federal funds rate is the interest rate at which banks lend reserves to each other overnight. It is set by the Federal Reserve’s Federal Open Market Committee (FOMC) and serves as the benchmark for nearly every other interest rate in the U.S. economy — from mortgages and auto loans to savings accounts and corporate bonds. When you hear that “the Fed raised rates” or “the Fed cut rates,” this is the rate they are talking about.

How the Federal Funds Rate Works

Banks are required to hold a certain level of reserves. At the end of each business day, some banks have excess reserves while others are short. Banks with excess reserves lend to banks that need them, typically overnight. The interest rate on these loans is the federal funds rate.

The FOMC meets eight times a year to set the target range for this rate. Their decision is based on the state of the economy — primarily employment levels and inflation. When the economy is overheating (high inflation), the Fed raises the target range to make borrowing more expensive and cool spending. When the economy is weakening (rising unemployment, falling demand), the Fed lowers the range to make borrowing cheaper and stimulate activity.

The Fed does not directly set the rate. Instead, it uses tools — primarily the interest rate on reserve balances (IORB) and the overnight reverse repo facility (ON RRP) — to keep the effective rate within the target range. These tools create a floor and ceiling for the rate, and the market determines the exact level within those bounds.

Why the Federal Funds Rate Matters for Investors

The federal funds rate is the foundation of the entire interest rate structure. Changes ripple through every corner of financial markets:

Mortgages and consumer loans: When the Fed raises its target range, mortgage rates, credit card rates, and auto loan rates tend to follow. A 1 percentage point increase in the federal funds rate typically translates to a 0.5 to 1 percentage point increase in mortgage rates, though the relationship is not exact because mortgage rates are influenced by other factors including Treasury yields and MBS demand.

Savings and money market accounts: Higher rates generally mean better returns on savings accounts, CDs, and money market funds. This is one of the few direct benefits to savers when the Fed tightens policy.

Stock valuations: Higher interest rates increase the discount rate used to value future corporate earnings, which puts downward pressure on stock prices — particularly for growth stocks whose value depends heavily on future earnings. Conversely, rate cuts tend to support stock valuations.

Bond prices: When rates rise, existing bond prices fall (because new bonds offer higher yields). When rates fall, existing bond prices rise. This inverse relationship is fundamental to fixed-income investing.

The U.S. dollar: Higher rates tend to strengthen the dollar because they attract foreign capital seeking better returns. A stronger dollar makes imports cheaper but exports more expensive, affecting multinational corporate earnings.

How to Track the Federal Funds Rate

The most authoritative source is the Federal Reserve itself. The FOMC releases a statement after each meeting (eight per year, plus emergency meetings when needed) that announces any changes to the target range. The statement also includes forward guidance — language that signals the committee’s likely future direction.

For real-time market expectations, the CME FedWatch Tool uses federal funds futures pricing to calculate the probability of rate changes at upcoming meetings. This is how traders and analysts gauge what the market “expects” the Fed to do.

The effective federal funds rate (the actual rate, as opposed to the target) is published daily by the Federal Reserve Bank of New York (FRED series: DFF). The target range boundaries are published as DFEDTARU (upper bound) and DFEDTARL (lower bound).

Federal Funds Rate History: Key Turning Points

Understanding rate history helps contextualize today’s policy environment:

1980-1981 (Volcker tightening): The Fed raised the rate to nearly 20% to break double-digit inflation. It worked, but triggered a severe recession. This remains the most aggressive tightening cycle in modern history.

2007-2008 (Financial crisis): The Fed cut the rate from 5.25% to effectively 0% (0-0.25% range) in just over a year as the housing market collapsed and the financial system teetered. Rates remained near zero for seven years.

2020 (COVID emergency): The Fed slashed rates to 0-0.25% in two emergency cuts within two weeks as the pandemic froze economic activity.

2022-2023 (Inflation response): The Fed raised rates from near zero to 5.25-5.50% in the fastest tightening cycle in four decades, responding to inflation that peaked at 9.1% (June 2022 CPI). This cycle included four consecutive 75 basis point hikes — the most aggressive since Volcker.

Common Questions About the Federal Funds Rate

Is the federal funds rate the same as the prime rate?

No. The prime rate is set by individual banks (though they typically move in lockstep) and is usually 3 percentage points above the federal funds rate. So when the fed funds target is 4.25-4.50%, the prime rate is typically around 7.50%. Credit cards, home equity lines, and many business loans are priced off the prime rate.

How often does the Fed change rates?

There is no fixed schedule for changes. The FOMC meets eight times per year (roughly every six weeks), but they only adjust the target range when economic conditions warrant it. In 2023, the Fed raised rates four times. In other years, the rate has remained unchanged for all eight meetings. Emergency inter-meeting changes are rare but have occurred during crises (2001, 2008, 2020).

What is a basis point?

One basis point equals 0.01 percentage points. A 25 basis point (bps) rate hike means the rate increased by 0.25%. A 75 basis point hike means a 0.75% increase. This terminology is standard in fixed income and central banking — you will see it in every FOMC statement and financial news report.