What it means
Banks are required to keep a certain amount of money parked at the central bank rather than lent out to customers. Some banks end the day with more than they need and others end up short, so the ones with a surplus lend to the ones with a shortfall, usually just until the next morning.
That overnight market for reserve balances is the federal funds market. The price of those loans is the federal funds rate, and the Federal Reserve steers it towards a published target range rather than setting it by decree.
It does this mainly by adjusting the interest it pays on reserve balances and by lending or absorbing cash in the money markets. Banks then trade around the difference, which keeps the actual traded rate inside the range.
This matters far outside banking because the federal funds rate is the anchor for short-term borrowing costs everywhere. Business overdrafts, floating-rate loans, credit card rates and the yields on cash deposits all move with it, usually within weeks.
A finance director planning a variable-rate facility is effectively forecasting this one number. The loans themselves are unsecured, meaning no collateral is pledged, and they settle the same day between the banks' accounts at the Federal Reserve.
Volumes are large and terms are short, so a quarter-point change produces modest sums on any single trade but very large effects in aggregate. It is worth separating the two things the phrase can mean.
Federal funds are the balances themselves, the federal funds rate is the price of borrowing them, and the effective federal funds rate published each day is the volume-weighted average of the trades that actually took place.
In practice
Real-world examples.
Example
A mid-sized manufacturer has a $10,000,000 revolving credit facility priced at a floating benchmark plus 2.5%. When the Federal Reserve raises its target range by 0.5%, the interest cost on a fully drawn facility rises by $50,000 a year. The treasurer takes that number to the board as the case for accelerating a fixed-rate refinancing.
Example
A community bank's asset and liability committee checks the effective federal funds rate each morning before deciding how much to leave sitting in overnight balances. On days when the traded rate runs at the top of the target range, the bank lends out more of its surplus instead of holding it. The extra income is small on any one night but meaningful across a full year.
Example
A software company holding $40,000,000 of cash from a funding round moves it into a money market fund whose yield tracks short-term rates. After a full percentage point of rate rises, the same balance produces an extra $400,000 of interest income a year, which the finance chief reports as a separate line below operating profit.
Formula
Calculation
Overnight interest = principal x federal funds rate x (days / 360). Money market convention uses a 360-day year rather than 365.
Suppose a regional bank ends the day with $50,000,000 more in reserve balances than it needs and lends the surplus overnight at a federal funds rate of 4.5%.
Interest = $50,000,000 x 0.045 x (1 / 360)
$50,000,000 x 0.045 = $2,250,000
$2,250,000 / 360 = $6,250
The lending bank earns $6,250 for one night. If it repeats the same trade every night for 30 nights, it earns $6,250 x 30 = $187,500 on money that would otherwise have sat in a lower-yielding balance.Case study
Seen in the real world.
Harbour Line Bancorp is an illustrative regional bank invented for this entry. It routinely ended each day with roughly $80,000,000 of surplus reserve balances that the treasury team left untouched, partly out of habit and partly because nobody had ever costed the alternative.
A new treasurer modelled the position at a federal funds rate of 4.5% and found that lending the surplus overnight would generate $80,000,000 x 0.045 / 360 = $10,000 a night, or roughly $2,500,000 across 250 business days. That was more than the annual salary cost of the entire treasury function.
The committee approved a standing arrangement with two counterparty banks and set a floor below which the surplus would be held rather than lent, so that an unexpected settlement could never leave the bank short. Within a year the additional income had covered the cost of the treasury system that made it possible, and the bank's interest margin improved without adding any new credit risk to its loan book.
Watch out
Common mistakes.
- Treating the federal funds rate as a rate that consumers or businesses can actually borrow at. It is a wholesale rate between banks, and every retail rate sits some margin above it.
- Assuming the Federal Reserve dictates the rate directly. It announces a target range and uses its own tools to keep the traded rate inside it, but the rate itself is set by banks dealing with each other.
- Confusing federal funds with federal government funding, grants or spending. The two have nothing to do with one another beyond the word "federal".
Questions
People also ask.
Is the federal funds rate the same as the discount rate?
No, the discount rate is what banks pay to borrow directly from the Federal Reserve, and it is normally set a little above the federal funds target range.
How quickly do rate changes reach business borrowers?
Floating-rate facilities usually reprice within a day to a quarter depending on the reset date, while fixed-rate loans only reflect the change when they are refinanced.
Do federal funds loans require collateral?
No, they are unsecured, which is why they are made between institutions that already know each other's credit standing well.
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