CFA, Finance, FRM

How is Fed Funds Rate calculated?

What is Fed Funds Rate?

The Federal Reserve’s (also known as Fed) requirement is that banks have to maintain a cash reserve and these will be equal to a certain percentage of their deposits. They must hold cash on hand each night and because of this requirement, banks cannot lend the entire amount they hold. Banks can hold this amount either with the Fed or in their vaults. If this amount falls below the desired level, then the bank has to borrow an amount to maintain the statutory limit. If the money exceeds the required level, then the same can be used by this bank to lend to other banks that face a shortfall. This is where the Federal funds rate steps in.

The Federal funds rate is the interest rate that banks charge other banks for overnight loans to maintain their reserve balances. Alternatively, if the bank borrows the amount from the Fed it is known as a discount rate, which is usually above the fed funds rate.

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As can be seen in the below chart due to COVID-19, the Fed has lowered its reserve requirements to zero to encourage banks to lend to consumers and businesses in need.

How is Fed Funds Rate is calculated?

The Federal Open Market Committee (FOMC) is the branch of the Federal Reserve Board that determines the direction of monetary policy. It meets eight times a year about seven weeks apart to set the federal funds target rate. The banks can either accept to lend at the target rate set by FOMC or the banks can negotiate and arrive at a weighted average rate which is known as federal funds effective rate.

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In the US, federal fund rates are one of the most important rates as it affects the US economy. These rates are calculated after taking into consideration the growth, inflation, recession, etc. The Federal Reserve can adjust the money supply i.e. when the supply of money is increased the rate of interest decreases and the banks are likely to borrow more. As the rates are low, banks lend more loans to consumers such as home loans, car loans, term loans and many more thus this leads to an expansion in an economy. Similarly, when the supply of money decreases the rate of interest increases thus, banks borrow less. As consumers, businesses are less likely to borrow, this slows down the economy.

Author: Swati Krishnamurthy

About the Author:

Swati is a freelance writer. She is a Financial Quality Compliance specialist having integrated knowledge and experience in Logistics, Audit, and Risk-mitigation for manufacturing and service sectors. Her passion in finance grew as she scored centum in financial management during her master’s degree. She’s a classical dancer who performs to express complex emotions through her dancing, and writes to express complex concepts into simple words.

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