The federal funds rate is the interest rate at which depository institutions lend reserve balances to each other overnight. Set as a target range by the Federal Open Market Committee (FOMC), it is the most important benchmark interest rate in the global financial system.
How It Works
The Fed doesn't directly set the rate β it sets a target range (e.g., 5.25-5.50%) and uses open market operations (buying/selling Treasuries) and the Interest on Reserve Balances (IORB) rate to keep the effective federal funds rate (EFFR) within the range. The New York Fed publishes the EFFR daily.
Transmission Mechanism
The fed funds rate influences virtually every interest rate in the economy: mortgage rates, credit card APRs, auto loans, business lending rates, and savings yields. When the Fed raises its target, borrowing becomes more expensive across the entire economy, cooling demand and inflation.
Historical Context
The rate reached a record high of 20% under Paul Volcker in June 1981 to crush double-digit inflation. It was held at 0-0.25% (the 'zero lower bound') for 7 years after the 2008 crisis and again during COVID (March 2020-March 2022). The 2022-2023 hiking cycle was the fastest in 40 years: from 0% to 5.25-5.50% in 16 months (525 basis points).
Why Markets Obsess Over It
Every FOMC meeting creates massive market volatility. The CME FedWatch Tool tracks futures-implied probabilities of rate changes. A surprise 25bp deviation from expectations can move the S&P 500 by 1-3%, the dollar by 0.5-1%, and 2-year Treasury yields by 10-25 basis points within minutes.