What is the federal funds rate?

The federal funds rate is the rate that a Federal Reserve District bank charges another bank for the overnight loans needed to meet the reserve requirements.

The Fed sets the requirements and is a certain amount of funds reserved against the deposit of their customers. This money is required to be in the vault or in the closest Federal Reserves Bank.

This is one of the main tools used in the Monetary Policy. The tools are listed as follows:

Reserve Requirements
Open Market Operations
Discount Rate

This is what news reports are referring to when they talk about the Fed changing interest rates. In fact, the FOMC sets a target for this rate, but not the actual rate itself (because it is determined by the open market).

The minimum required amount of funds available in the vault or no interest bearing in the Fed. The amount of these reserves is based on the outstanding assets and liabilities of each depository institution. This is as well by the Fed itself. However, that is typically 10% of the bank's demand accounts.

The demand accounts is the deposit account held at a bank or financial institution.This is for the providing frequent and secure access to funds on demand, through several channels.

So looking at this in lemans terms, if one bank does not have enough money to cover the required reserves needed, they would need to borrow the money from another bank. The federal funds rate regulated the rate on the money loaned to the other bank.

Very few entities have the ability to move the economic markets as the Federal Reserve. This is why investors spend so much effort on the Fed and how its influences work.

The governors in the Federal Reserves set the rate as a target. This is enforced primarily by the Open Market Operations. The Open Market Operations is the buying and selling of bonds.

The other way a bank can keep their reserve to the minimum requirement is to borrow from the Federal Reserves itself. These loans have a lower rate, are for a short term, and they are somewhat rare. This is the main reason that the loans from other financial institutions is more easily obtained and have their popularity.

The Fed lowers the Federal Funds rate by purchasing Treasuries from banks and increasing the "monetary base" - bank reserves plus currency in circulation.

The only thing that the Fed can control with certainty is the monetary base. Alternately, it can try to control the Federal Funds rate (and passively adjust the monetary base by whatever amount is required to keep Fed Funds on target).

However, the Fed cannot control the Federal Funds rate with certainty. For example, if inflationary pressures were high and interest rates were moving up, the Fed could not predictably lower the Fed Funds rate by easing monetary policy.

Easier monetary policy, accomplished by the Federal Reserve's reduction in the federal funds rate on overnight bank deposits, promotes a healthier financial environment for agriculture by reducing credit costs.

The Federal Funds Probability directly shows the probability of actions that the Federal Reserve will take at the Federal Open Market Committee will take. The members of the FOMC will decide if there will be an increase, decrease or leave of the federal funds rate.

The interest rate on federal funds tends to show great information on future movements in the economy. The funds rate sensitively record shocks to the supply of bank reserves.