How the Federal Fund Rate Works

Federal Reserve Image:
Federal Reserve

An experienced real estate professional, Maxine Hepfer currently works as a senior in Ernst & Young’s Transaction Real Estate group in Dallas, Texas. Maxine Marie Hepfer is a member of the team that recently published an article on the effect of a Federal Reserve rate hike.

The federal funds rate is the interest rate at which depository institutions such as banks and credit institutions borrow from each other overnight. The rate is set by the Federal Reserve’s policymaking committee, the Federal Open Market Committee, and is reviewed periodically. Applicable to creditworthy institutions, the interest rate is a tool used by the Federal Reserve to check the market’s liquidity.

How this works is simple. Banks and credit institutions are required to maintain a reserve of funds with the Federal Reserve so that they are able to execute their financial operations. The reserve requirement ensures banks do not lend out every dollar they have. These reserves are capped at a specific figure every end of day. Banks with reserve funds way above the end-of-day requirements can loan their excess funds to banks with lower reserves. They do this using an interest rate negotiated between the two, centered on the federal fund rate.

When the federal fund rate is increased, banks are generally more reserved in their lending. The trend trickles down to the open market, reducing the flow of money. A low interest rate encourages lending, in turn boosting the flow of money and economic growth.

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