Federal funds, often called fed funds, are surplus reserves that commercial banks and other financial institutions deposit at regional Federal Reserve banks. These funds serve as loans that can be lent to other market participants needing cash to meet their lending and reserve needs. Such loans are unsecured and made at a relatively low-interest rate, known as the federal funds rate or overnight rate.
Key Takeaways
- Efficient Reserves: Federal funds represent excess reserves held by financial institutions, beyond the mandated reserve requirements of the central bank.
- Overnight Lending: Financial institutions lend or borrow their excess funds on an overnight basis to manage their reserves efficiently.
- Federal Funds Rate: Though the central bank sets a target, the actual market rate for federal fund reserves is influenced by inter-bank overnight lending.
Mastering the Concept of Federal Funds
Federal funds enable commercial banks to maintain their daily reserve requirements, which is the sum banks must keep at their regional Federal Reserve based on their deposit volumes. Excess reserves are cash that exceeds what is mandated by regulators, creditors, or internal controls. For commercial banks, this means reserves exceeding standard requirements set by central banking authorities.
The central bank periodically adjusts the target rate or range for the fed funds rate based on prevailing economic and monetary conditions.
Navigating the Overnight Markets
The fed funds market in the U.S. is comparable to the offshore eurodollar deposit market. Eurodollars, traded similarly to fed funds and often structured overseen by branches in the Caribbean or Panama, cater primarily to multinational banks. These transactions can range from $2 million to upwards of $1 billion.
Understanding The Fed Funds Rates
The Federal Reserve employs open market operations to manage the monetary supply and adjust short-term interest rates by buying or selling government-issued bonds and bills. This, in turn, influences the monetary supply and alters short-term interest rates. These operations are carried out by the Federal Reserve Bank of New York.
The fed funds rate significantly impacts the U.S. economy, affecting factors like inflation, growth, and employment. Notably, it is aligned closely with broader market short-term interest rates, influencing eurodollar and LIBOR rates as well.
Spotting Market Participants
Participants in the fed funds market include U.S. commercial banks, U.S. branches of foreign banks, savings and loan organizations, government-sponsored enterprises (like Fannie Mae and Freddie Mac), and federal government agencies. This breadth of participants highlights the centrality of the fed funds market in the economic ecosystem.
Related Terms: central bank, commercial bank, federal funds rate, reserve requirements, economics.
