What Is the Fed Funds Rate?

what is the fed funds rateThere's been a lot of talk of when - and even if - the U.S. Federal Reserve will raise interest rates soon.

But the mechanism for which the Fed raises rates, the so-called "Fed funds rate," is hardly well-understood.

So, what is the Fed funds rate? And how does the Fed set interest rates?

The methods for interest rate setting are rather complex.

And the typical monetary policy procedures have altered dramatically since the global financial crisis.

But before answering "what is the Fed Funds rate?" - and how the Fed sets that rate - you'll have to understand some key banking concepts...

What Is the Fed Funds Rate?

To understand the Fed funds rate, we'll first need to answer the question, "What are bank reserves?"

Bank reserves show up as an asset on a commercial bank's balance sheet and a liability on the Fed balance sheet. Think of reserves as a commercial bank's checking account at the central bank in the same way you might have a checking account with your commercial bank.

Reserves are made up of deposits at the bank.

When a bank customer withdraws money from their electronic account, converting them to paper currency, or makes an electronic payment, a bank's reserves will go down.

In one case, reserves are leaving the bank in the form of paper currency to be held by an individual, and in another case, reserves are being transferred from one bank to another.

You'll notice that in the aggregate, reserves can't be created, only shifted around within the interbank market or converted into cash through withdrawals.

That's where the Fed comes in. The Fed creates reserves for which banks can use to settle interbank payments and meet Fed-mandated reserve requirements.

So, how does the Fed create reserves?

Where Do Reserves Come From?

The Fed creates reserves through open market operations.

It will either buy assets, typically U.S. Treasuries and other bonds, from depository institutions, or sell assets to the banking system.

This is how it works.

The Fed will remove a bond from the asset side of a bank's balance sheet. That bond will then show up as an asset on the Fed balance sheet. The Fed will then credit the bank's assets with reserves equal to the value of the bond. Those reserves become an asset to the bank but a liability to the Fed, since reserves are the bank's checking account at the Fed from which it can draw money.

This is typically viewed as "money printing" because the Fed is creating assets where there were none. But really these reserves are created with keystrokes on an electronic spreadsheet from thin air.

This won't affect the size of the bank's balance sheet - it will only rearrange the composition of its assets.

When the Fed wants to extinguish reserves, it will sell bonds that the banks will then purchase with reserves.

From here we can begin to understand the Fed funds rate...

What Is the Relationship Between Reserves and the Fed Funds Rate?

The Fed decides what percentage of a bank's liabilities must be held in a reserve account at the Fed.

For any bank holding up to $14.5 million in liabilities, there are no reserve requirements. Between $14.5 million and $103.6 million in liabilities, banks are required to hold 3% in reserves. Above $103.6 million, the reserve requirement is 10%.

what is the fed funds rate chartOver a 14-day period, from a Monday to the second Monday thereafter, a bank will be in what's called a "reserve computation period." Over these 14 days, the bank will determine the average level of net transactions and cash held in vaults as funds are withdrawn and deposited in that period.

The bank will use that average number to determine the level of reserves it needs to hold in what's called the "reserve maintenance" period. This period comes 17 days after the end of the reserve computation period, beginning on a Thursday and ending on the second Wednesday thereafter.

The accompanying diagram shows how this schedule breaks down.

As banks settle interbank payments, there is bound to be a mismatch somewhere. Some banks will be left with reserves in excess of requirements, while others will fall short. If one bank's reserves fall below these requirements, they will borrow those reserves overnight from other banks in the Fed funds market.

The Fed funds market is the banking system's aggregate of excess reserves that banks short of reserves will bid on to meet requirements. The rate at which they borrow these funds, typically overnight (hence, the often used term "overnight rate"), is what is called the Fed funds rate.

And now, we'll explain how the central bank sets these rates and how that determines interest rates in the economy.

How the Fed Funds Rate Works

The Fed will typically target a rate and will seek to hit that target through open market operations.

So, there's the target rate, the rate the Fed wants banks to lend to each other, and the effective rate, the actual rate at which they lend to each other in the Fed funds market.

When excess reserves are scarce, there will be higher demand from banks with insufficient reserves. This will bid up the interest rate to borrow Fed funds as the bank with excess reserves will see a profit opportunity.

But if the Fed steps in and begins buying up banks' bonds with newly created reserves, it drives down the demand on the Fed funds market and the interest rate will come down.

So, if the Fed has a target of 2.5% but the effective rate is 3%, the Fed will buy bonds and create reserves until that rate is driven down to the target and will intervene with open market operations accordingly to maintain that level.

The Fed will do the opposite, sell bonds and extinguish reserves, to bring the rate up.

This helps to set rates across asset classes because when the rate is high for banks to borrow from each other, they'll have to lend at an even higher rate to remain profitable.

So when the economy is slow and the Fed wants to spur bank lending, while it can't do it directly because it can't force banks to lend, it'll drive down the Fed funds rate in an attempt to give banks more space to lower rates on loans to consumers.

When the economy is overheating and the Fed wants to slow lending down, it'll start working to drive rates up to diminish loan demand in the economy.

But monetary policy has seen a fundamental shift since the financial crisis...

How the Global Financial Crisis Has Changed Fed Operations

Since the financial crisis the Fed has pursued two policies that have changed the way rates are set.

The first is quantitative easing (QE), the large-scale purchase of bank assets with newly created reserves. Rather than simply step in and out of the Fed funds market with open market operations, in QE, the Fed floods the banking system with so many excess reserves that demand for Fed funds falls and the rate drops to 0%.

QE is another monetary policy tool at the Fed's disposal used when conventional interest rate measures have been exhausted. To put QE in perspective, there are about $2.5 trillion in excess reserves in the banking system right now. Compare that to the pre-QE level of $1.9 billion.

When the Fed continues to buy assets, it has the effect of further driving down interest rates, and that will in turn have investors looking for higher-yielding assets in which to put their money, such as equities. It's a part of a portfolio rebalancing effect aimed at easing financial conditions.

The Fed also enacted a policy of paying interest on excess reserves of 0.25%. That means by keeping reserves at the Fed, the bank earns interest of 0.25%, just by letting it sit in its checking account. So, it will be more profitable for banks to simply sit on reserves than lending them out to other banks at less than 0.25%.

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When the Fed wants to raise interest rates, it has to do one of two things.

It can use the traditional procedures for extinguishing reserves and selling bonds to shrink its balance sheet.

Or, since the Fed now pays interest on reserves following the financial crisis, it can simply raise that rate. The Fed doesn’t necessarily need to intervene with open market operations to affect the quantity of reserves anymore.

However, it's still questionable that paying higher rates on reserves is going to get banks to raise their own rates.

"If you give the banks more income - if you subsidize them - you are lowering their costs of funds. Where is the incentive for them to raise rates? That's my question," Lee Adler of WallStreetExaminer.com told Money Morning. "It makes no sense that if you pay the banks more money in interest that they'll charge more."

Bottom Line: The jury is still out on when the Fed is going to raise rates. While the mechanisms were once very complex - the Fed had to actively manage the quantity of reserves in the banking system to influence demand by the banks - the financial crisis has changed that. Now, the Fed can simply declare that it's going to pay higher interest on reserves for banks. Whether that encourages banks to lend at higher rates or not is still a question mark, making the method the Fed will take to raise rates even murkier.

Jim Bach is an Associate Editor at Money Morning. You can follow him on Twitter @JimBach22.

Exclusive: Jim Rickards has been speaking out on the dangers of Federal Reserve policy for several years. Recently, Money Morning conducted an exclusive interview with Rickards that covered not just the Fed, but an entire series of economic threats he believes could send America into a 25-year depression. To watch this must-see interview, click here.