What is the Fed Funds Rate (FFR)?
The Fed Funds Rate (FFR) is the interest rate charged on overnight loans between banks in the United States. This rate is a key benchmark for banks when setting the interest rates they offer to customers for savings, loans, and other financial products. Internationally, the FFR has a broad impact due to the US Dollar being the world's primary reserve currency.
FFR as a Monetary Policy Tool
The Federal Reserve (The Fed) uses the FFR as a primary tool in monetary policy to control the money supply and achieve inflation targets. Additionally, the FFR helps support sustainable economic growth. The FFR can influence various economic aspects, including inflation levels and GDP growth. Historically, from 2008 to 2015, The Fed maintained a zero-percent interest rate to combat deflation following the 2008 financial crisis. In 1979, Paul Volcker, then Chairman of The Fed, used the FFR to tackle stagflation.
Economic Indicators Monitored
The Fed monitors several economic indicators to decide on changes to the FFR, including:
- Core Inflation: Measures price changes in all sectors except food and energy, which are considered volatile.
- Core PCE Index: The inflation indicator used by The Fed.
- Unemployment Rate: Tracks the health of the labor market.
- Nonfarm Payroll (NFP): Employment data showing the number of new jobs.
- Wage Growth: Observes changes in employee wages over time.
Impact of FFR on the Market
- Short-Term Interest Rates: Banks use the FFR to determine their short-term interest rates, including the Libor (London Interbank Offered Rate). The FFR also influences the Prime Rate applied to customer loans.
- International Capital Flows: An increase in the FFR can attract foreign investors to US Dollar-denominated assets, while a decrease might encourage investors to seek higher-risk investments in emerging markets.
- Global Economy: Changes in the FFR affect global capital flows and can impact countries with weaker economies. For example, a rise in the FFR might lead to capital outflows from emerging economies like Indonesia.
FFR Determination by the FOMC
The FFR is set by the Federal Open Market Committee (FOMC), which consists of senior officials from the US central bank. The FOMC meets eight times a year to decide on monetary policy, including setting the FFR. The FOMC’s decisions are made through a vote, and they use open market operations to influence the FFR. If the FOMC wants to lower the FFR, they will buy securities from member banks, increasing liquidity and encouraging banks to lower their rates. Conversely, to raise the FFR, they will sell securities, decreasing liquidity and encouraging banks to raise their rates.
Impact of Changes in FFR
Changes in the FFR do not immediately impact the economy. Typically, effects become visible 12 to 18 months after a change. Therefore, The Fed needs accurate economic predictions, supported by a skilled team of economists.
The Fed Funds Rate is a crucial interest rate influencing the US economy and global markets. As a monetary policy tool, the FFR helps control inflation and support economic growth. Changes in the FFR can impact short-term interest rates, international capital flows, and the overall global economy. Through FOMC meetings and open market operations, The Fed can influence the FFR and, consequently, the economic and financial market conditions.
