What is the Federal Funds Rate?
The Federal Funds Rate is the interest rate at which US banks and other depository institutions lend excess reserves to one another. The Fed Funds Rate influences the interest rates on savings accounts, credit cards, mortgages, and commercial loans.
There are two rates to be aware of:
- The federal funds target rate is set by the FOMC (Federal Open Market Committee). This is the rate at which the FOMC suggests banks lend excess reserves to one another. Typically, the FOMC will set a target range rather than a single rate.
- The effective federal funds rate (EFFR) is the median rate at which institutions actually lend to one another. The EFFR for each day is published the following day by the Federal Reserve Bank of New York.
The target rate is one of the primary tools the Federal Reserve uses to promote economic growth and to control inflation. When the Fed is said to be increasing or decreasing interest rates, it typically implies that they are changing the federal funds target rate.
How does the Fed Funds Rate work?
Deposit-taking institutions are required to maintain reserves proportional to their assets and liabilities. Excess reserves can be lent overnight to other institutions with a reserve deficit. The rate at which these loans are made affects the interest rates for an institution’s other loans and deposits. So, by influencing the rate at which these interbank loans are made, the Federal Reserve can influence interest rates in the economy.
The FOMC sets a target rate range but does not dictate the rate at which banks lend to one another. Instead, the central bank conducts open market operations to add or remove liquidity from the banking system.
This is done by buying and selling government bonds and entering into repurchase agreements with banks. These activities increase and decrease the amount of excess reserves which in turn forces rates up and down.
The central banks can also influence rates by adjusting the discount rate, which is the rate it charges when it lends directly to institutions. The discount rate is typically higher than the fed funds rate, so institutions are incentivized to borrow from one another first.
The effective federal funds rate is calculated as the median rate at which overnight federal funds loans. The rate that is published each day is the effective rate for loans made the previous day.
What is the current Federal Funds Rate?
As of 17 March 2022 the effective federal funds rate was 0.33%.
The FFR target range was 0.25 to 0.5%
On 16th March 2022, the target range was raised from 0 to 0.25% to 0.25 to 0.5%. This resulted in the EFFR rising from 0.08% to 0.33%.
The highest EFFR during the last 12 months was 0.33%.
The lowest EFFR during the last 12 months was 0.06%
Key FFR trends and levels
In the period since 1950, there have been two dominant trends in the FFR. These trends have mirrored the behavior of other key US interest rates.
Between 1950 and 1981, the FFR rate rose from about 1% to a peak of 19.1% in June 1981. This was a period of rising inflationary forces, including rapid economic growth and rising consumer spending. The FFR peaked shortly after inflation reached record levels due to the 1970s oil crisis.
Since 1981, the FFR has fallen steadily, reaching a low of 0.05% in March 2020. During this period inflation fell due to improved productivity and globalization. The FFR fell to record lows during the GFC (global financial crisis) in 2008 and the Covid-19 pandemic in 2020.
In early 2022, the target range for the FFR was raised for the first time since 2018.
How to use the Federal Funds Rate?
Changes in the federal funds target rate give investors an indication of the central bank’s expectations for the economy and inflation. At a very basic level, when the target rate is increased it indicates that the economy is growing, but that inflation may become a concern. When rates are lowered, it suggests that inflation is less of a concern but growth may be slowing.
While the fed funds rate itself affects economic activity, the likely direction of future rate adjustments is most important for stock market investors. Interest rates go through tightening and easing cycles, and the length and magnitude of these cycles determine their impact on stock prices. Analysts play very close attention to the minutes of FOMC meetings and to public statements made by members of the committee.
The impact of changes in the fed funds rate on stock prices depends on their level, the direction and magnitude of changes and on the length of a cycle.
Level of the FFR
Higher rates impact the cost of doing business for companies. When rates rise above 10% it becomes difficult for many businesses to generate profits and returns for shareholders. When rates are lower than 5%, the environment is generally positive for stocks.
Direction of changes to the FFR
When rates rise, it usually means the economy is in good shape, but that potential inflation may lead to more increases in the future. When rates decrease, it may indicate that the central bank is concerned that economic growth may slow down. Individual changes in the fed funds rate often have little impact on the stock market if they are anticipated.
Typically rising rates benefit cyclical stocks while falling rates benefit growth stocks.
Magnitude of the change
Markets don’t like uncertainty or sudden changes in the economy. Sudden or substantial changes in the fed funds rate can both be negative for stock prices. If rates rise sharply, it may indicate that the central bank believes the economy is getting overheated. Rates usually decrease sharply when there’s already a correction or financial crisis unfolding.
5.4 Cycle length
Gradual changes in interest rates in both directions can be beneficial for stock prices, as long as rates do not get too high. If there is an established cycle in place, companies are able to plan and continue to invest. Stock market volatility often increases in the early stages of a new cycle and then decreases as the cycle continues.
Interest rates and the direction they are headed provide valuable context for investors, but need to be used alongside other indicators. These indicators include:
- AAII Sentiment
- VIX Index
- S&P Market-Cap Concentration
- Personal Savings Rate
- Buffet Indicator
- Put/Call Ratio
- Margin Debt to Cash
- Velocity of M2 Money Stock
- Debt / GDP ratio
- Unemployment rate
- Shiller P/E ratio
- DXY index
What are the limitations of the Federal Funds Rate?
The target fed funds rate is only set periodically, so changes may reflect changes that have already occurred in the economy. The market is usually more concerned with what will happen at the next FOMC meeting than the rate that has already been announced.
As is the case with bond yields, the fed funds rate reflects expectation for both inflation and growth. This means the way it is interpreted can be ambiguous.
Is the Federal Funds Rate a reliable indicator?
The Fed Funds Rate is the US central bank’s primary tool for influencing economic activity. Changes to the FFR give us a clear indication of what the Fed is trying to do, and its expectations for economic growth and inflation. However, it’s important to remember that expectations for the Fed’s next move are more important than the current rate.
In addition to the Federal Funds Rate, you can use our complete list of 12- essential market indicators to make educated financial decisions.
