What Is the Federal Funds Rate?
The federal funds rate can impact a host of borrowing costs, and thus the entire U.S. economy. Here's how it works.
If you've been paying attention to chatter about interest rates in recent years, you've probably come across the term "federal funds rate" — or just "fed funds rate" for short. But what exactly is the federal funds rate, and why does it matter?
The factors behind this key interest rate can be confusing, but the simplest way to think about the federal funds rate is to consider it the first link in the chain for all borrowing across the financial sector.
As such, an increase in the fed funds rate increases several other interest rates. This is what makes the federal funds rate a crucial cog in the engine of the U.S. economy, where even small changes in this interest rate can have meaningful consequences.
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What is the federal funds rate?
To have a complete understanding of what the federal funds rate is, you first have to understand the basics of how the Federal Reserve works.
The Federal Reserve — or simply "the Fed" — provides central control over the nation's monetary supply and currency.
It is one of about 150 central banks on the planet, each designed to guard against financial crises or nudge local economies in the right direction.
Generally, banks make money by taking deposits from customers and lending that cash out again to third parties. A little of this behavior is fine since it's rare for every customer to demand their entire deposit back at the same time.
However, it can happen, as we saw in early 2023 with the collapse of Silicon Valley Bank.
To ensure banks have a cushion, the Fed requires a minimum percentage of total deposits to be kept under its oversight. These are the "reserves" that make up the foundation of the Federal Reserve System.
This figure can be just a few million dollars for your favorite local bank, and much higher for major lenders such as Bank of America (BAC) that have billions in deposits. Whatever the bank's specific threshold is, it must meet it at the end of every day.
Banks with more cash than required can lend to other banks that come up short, though, and the interest rate on these short-term interbank loans is the federal funds rate.
Why the federal funds rate matters
If you think overnight loans between two megabanks are merely a behind-the-scenes detail, think again. Indirectly, this rate impacts everything from mortgages to auto loans to credit cards.
Here's how: Let's say that Bank A has to borrow from a competitor's excess funds to meet its deposit obligations at the Federal Reserve.
If the federal funds rate is fixed at 0.5%, a historically low rate, why wouldn't it lend aggressively and pay the modest interest expenses to Bank B when it comes up short on deposits?
But if the federal funds rate is a costly 5.0%, Bank A is far less inclined to borrow from peers. It is also incentivized to keep excess reserves and lend them out to other banks for a tidy profit.
And in a higher-interest-rate environment, banks are much more likely to demand that consumers and businesses pay a higher rate on all loans. After all, if an interbank loan is going for 5%, then why would you decide to charge anyone else less than that amount?
How is the federal funds rate set?
The Federal Open Market Committee, or FOMC, sets the fed funds rate. There are eight regularly scheduled FOMC meetings throughout the year, and its members include top officials from the U.S. Federal Reserve System.
The Fed looks to change policy based on its formal mandate from Congress to achieve "maximum employment, stable prices, and moderate long-term interest rates."
There are no hard-and-fast rules on what that means, and it's difficult to balance all those things perfectly. However, we can generally expect rates to drop if unemployment gets too high, and you can expect rates to rise if prices get too high.
In recent decades, the Fed has come to understand the power of the federal funds rate to change investor, business and consumer behavior.
As such, the central bank attempts to offer transparency in its process, as well as regular updates and projections of where the federal funds rate could wind up if current trends persist.
The Fed does reserve the right to hold unscheduled FOMC meetings to change rates in an emergency. This happened during the 2008 financial crisis, and as recently as March 2020 in reaction to the unexpected shocks caused by the COVID-19 pandemic.
What is the current federal funds rate?
In July 2023, the FOMC raised interest rates by 25 basis points (0.25%), bringing the federal funds rate to a target range of 5.25% to 5.50%. This was its highest level since early 2001.
However, in September 2024, the Fed began to cut rates, kicking things off with a jumbo-sized 50 basis points (0.50%) followed by two quarter-point rate cuts to bring the fed funds rate to a range of 4.25% to 4.50%.
Stubborn inflation and a strong economy prompted the central bank to pause rate cuts in January 2025. The central bank held the federal funds rate steady until late 2025, when it lowered the federal funds rate to its current level of 3.50% to 3.75%.
With the inflation outlook clouded by a potential energy shock amid a war between the U.S. and Iran, it has held rates steady so far in 2026.
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