The Federal Fund holds reserves for various financial institutions.The Federal Reserve, like many Central Banks, requires banks to maintain a cash reserve ratio, which is a percentage of the amount of deposit liabilities that commercial banks owe to its customers. An amount stays in cash with the commercial bank and the rest of the requirement fund is put in an account with the federal reserve.
These institutions borrow or lend these funds on an overnight basis without collateral. This is a common practice. Negotiations between the borrowing bank and lending bank are fixed. The weighted average across all similar transactions is called the Federal Fund Rate.
The governors at the Federal Fund set these rates, which are a range, rather than a set number. It is the nominal federal rate. The rate is enforced through open market operations. The Federal Reserve buys and sells government bonds in the open market. It can also enter a repo with the commercial bank, in which it advances a loan against an eligible asset.
In its press release dated 2nd November 2016 the Federal Reserve set its target rate between 1/4 and 1/2 percent. In explaining the rationale for the rate as well as the way forward, the press release stated:
The Committee judges that the case for an increase in the federal funds rate has continued to strengthen but decided, for the time being, to wait for some further evidence of continued progress toward its objectives. The stance of monetary policy remains accommodative, thereby supporting further improvement in labor market conditions and a return to 2 percent inflation.
In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments. In light of the current shortfall of inflation from 2 percent, the Committee will carefully monitor actual and expected progress toward its inflation goal. The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.
The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction, and it anticipates doing so until normalization of the level of the federal funds rate is well under way. This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.
The Federal Fund Rate is a very important rate since the Fed manipulates this rate which in turn impacts all other interest rates. We close this post with this video by Josh Wenzel to better understand the Federal Fund Rate.