Federal funds are the funds that depository institutions keep in their accounts at the Federal Reserve bank in their district. Depository institutions are financial institutions that accept deposits and make loans, which include commercial banks, savings banks, savings and loan associations, credit unions, thrifts, as well as U.S. branches and agencies of foreign banks, and other domestic banking entities that finance international transactions. Commercial banks are the largest holders of federal funds. Money is kept in these accounts because the Federal Reserve requires that a certain percentage of the institution's deposits be kept in its Federal Reserve account (reserve requirements), and because this money is used to clear transactions with other banks. For instance, if a customer writes a check for $100 to a business with a different bank, then the business deposits the check with its bank. The bank sends the check to the Federal Reserve bank in its district, where the Federal Reserve credits the bank of the business for $100 and debits the bank of the customer for $100. Hence, the reserve balance of the business's bank increases by $100 and the reserve balance of the customer's bank decreases by the same amount.
On each business day, banks decide how much reserves they want to have at the end of the day. As the day progresses, business activity will either increase or decrease the amount of reserves that they will have. It is this daily difference between actual reserves and desired reserves that causes banks to borrow or lend to each other. In the United States, banks must formally satisfy the reserve requirements at the end of each 2-week reserve maintenance period.
Small banks generally have excess reserves, while large commercial banks in major urban centers usually have less than the required reserves. Hence, the large commercial banks borrow from the smaller banks to maintain their required, or desired, level of reserves. Generally, the banks deal directly with each other, and with correspondent banks, which have accounts at the commercial bank. However, if a bank cannot satisfy its reserve requirements from its traditional lenders, then it will use a broker. This interbank lending and borrowing to maintain levels of reserves constitutes the federal funds market. The terms for most transactions are overnight because reserves fluctuate daily, but can range up to 6 months.
Federal Funds Rate
The federal funds rate determines all other money market rates and interest rates in general, including the interest rate on mortgages and consumer credit. The federal funds rate is largely determined by the Federal Open Market Committee (FOMC), which implements monetary policy through open market operations that targets the federal funds rate. The FOMC sets the target federal funds rate, which is the interest rate that is usually reported in the news after an FOMC meeting.
When the economy is operating at less than its potential output, then the FOMC sets a lower target federal funds rate, which stimulates the economy. If the economy is overheating, then the target federal funds rate is set higher, to slow the economy down to its potential output.
The interest rate paid for this borrowing is the federal funds rate (aka market federal funds rate), which can range from 10 to 200 basis points above the general repo rate, but averages around 25 basis points above the repo rate. The Fed publishes the effective federal funds rate daily, which is the average interest rate on all trades of federal funds weighted by the sizes of the trades. The federal funds rate is always higher than the repo rate because there is no collateral backing federal funds borrowing. Since these loans are unsecured, banks only lend out to other banks that they deem creditworthy.
The Fed adjusts the federal funds rate indirectly through open market operations that increase or decrease the reserve balances of banks — and therefore the supply and demand for reserves — by buying or selling securities until the market federal funds rate is approximately equal to the target rate. When the Fed buys securities, it increases the supply of money in the banking system, thereby lowering the federal funds rate, and when it sells securities, it decreases the supply of money, thereby raising the federal funds rate. For instance, if the Fed buys $1 million worth of Treasuries from a dealer, then the Federal Reserve account of the dealer's bank is credited for $1 million, which increases that bank's reserves, and thereby decreases that bank's demand for federal funds. If it sells $1 million worth of Treasuries to a dealer, then the Federal Reserve account of the dealer's bank is debited $1 million, which increases the bank's demand for federal funds, which increases the market rate.
The upper limit to the federal funds rate is the discount rate, the rate at which the Fed lends to banks at its discount window. Although the federal funds rate is a market rate kept within a narrow range by the market operations of the Fed, the discount rate is set by the Federal Reserve. The discount rate is set 100 basis points above the target federal funds rate. If the market rate rises above the discount rate, then the banks will borrow from the Fed rather than pay higher market interest rates.
Banks have a federal funds desk whose main purpose is to manage the bank's reserves. If its reserves is less than required or desired, then the bank will borrow the money, usually either from other banks or through the repo market. However, since the Federal Reserve pays little interest to the banks for their reserve requirements, keeping more than is necessary incurs an opportunity cost — the lost interest that could be earned if it were either lent out or used to buy interest paying securities.