Federal Funds Rate

The federal funds rate is the interest rate on loans of funds held mainly by banks and other financial institutions in accounts at the Federal Reserve Banks.¹ The primary way the Federal Reserve’s Open Market Committee (FOMC) implements monetary policy is by targeting the federal funds rate. The Fed has published the federal funds rate series daily since July 1954.² However, the federal funds market came into being in the 1920s and quickly became an important part of the money market.

Daily federal funds rate quotes were first published in April 1928 in The New York Herald-Tribune, which observed that "many students of the day-to-day fluctuations of money rates have turned to the current quotation for Federal Reserve funds as an indicator of the easiness or tightness of money...[I]t has become a most important rate to be scanned for the information it reveals."³ Market quotes later appeared in other papers as well.⁴

Market Origins

Before the founding of the Federal Reserve System ("Fed"), the United States already had an active overnight lending market in the form of "call money" (or "brokers") loans in New York City.⁵ Borrowers used debt and equity securities as collateral for call money loans. These loans were renewed day after day until the borrower repaid the loan or the lender "called" it (requested repayment). Borrowers were mainly securities brokers and dealers in New York City who borrowed funds to finance inventories of securities or their customers’ purchases of securities on margin. The immediate lenders were New York City banks, but New York banks often acted as agents for other banks, businesses, and private individuals located elsewhere in the United States and Canada. Banks outside of New York also supplied funds to the call money market indirectly through the deposits they held with banks in New York. Most call money loans were arranged on the trading floor of the New York Stock Exchange (NYSE). Rates for call money loans were widely reported in newspapers and commonly viewed at the time to be the best indicators of conditions in short-term money markets.

The Fed began to operate in November 1914. It soon developed a telegraphic network through which a bank with a Fed account could order an immediate transfer of funds to the Fed account of another bank anywhere in the system.⁶ This made it possible to lend "federal funds"—that is, funds on deposit at Federal Reserve Banks—nationwide on an overnight schedule.

The first federal funds loans were made between New York City banks in the summer of 1921, as banks anticipating shortfalls in their Fed accounts entered into agreements to acquire funds from banks with surplus balances in their Fed accounts. For example, a bank might borrow federal funds to ensure that its reserves did not fall below the minimum required by law or to cover deposit withdrawals or other payments. A lender of federal funds would typically be a financial institution with surplus funds seeking to earn interest on those funds.⁷ Most of these transactions were overnight loans, in which the lending bank either provided a draft on its Fed account to the borrowing bank or arranged with the Federal Reserve Bank of New York to transfer funds from its account to the account of the borrowing bank. Either way the funds would be in the borrower’s account by the end of the same day. In return, the borrowing bank would issue a cashier’s check for principal and interest to the lender drawn on clearinghouse funds. The lender sent the check to the clearinghouse by the end of that day and received payment in the following day’s clearinghouse settlement.⁸

By 1925 banks outside New York City were lending federal funds locally. Lending between banks in different Fed Districts was common by the end of the 1920s.⁹ Other participants in the market were dealers in bankers’ acceptances and government securities (known in the 1920s as "discount houses").¹⁰ These firms received payments in federal funds when they sold securities to Federal Reserve Banks and needed to make payments in federal funds for some of their purchases. Some dealers maintained "nonmember clearing accounts" at the Fed and transferred federal funds through reserve accounts of Fed member banks with which they had relationships. Several dealers became active borrowers and lenders of federal funds, and some became federal funds brokers, facilitating loans between others. Federal funds trading grew from a daily volume that rarely exceeded $20 million in 1921 to average $40 to $80 million by 1925 and after 1925 "ranged upward from $100 million, reaching $250 million at times."¹¹

Although federal funds trading grew over time, market volume remained small relative to other money market instruments throughout the 1920s.¹² Federal Reserve policymakers of the time appear to have paid little attention to the federal funds market, or perhaps took it for granted. Two of the Fed’s leading economists at the time, W. Randolph Burgess¹³ and Winfield Riefler,¹⁴ hardly mention the federal funds market in their discussions of the money market and Federal Reserve policy. Nonetheless, the market was an important source of liquidity and a barometer of overall money market conditions. The market was also acutely sensitive to Fed policy rates and actions, as it is today. Differences in discount rates among the 12 Reserve Banks, which generated flows of funds between regions, could affect market trading.¹⁵ The Fed’s open market operations directly affected the supply of bank reserves, which affected the federal funds rate. According to Willis (1970, p. 13), the federal funds rate "tended to be more sensitive [than other money market rates] and anticipate changes in bank reserve positions and factors affecting them because the use of funds offered an alternative to borrowing at the Reserve Banks."

Monetary Policy Instrument

The federal funds market developed in the 1920s as the Fed was learning to use its policy tools to achieve macroeconomic, international, and financial stabilization goals. The federal funds rate reflected the impact of the Fed’s actions on the money market, but the Fed did not specifically target the rate. During the Great Depression, there was much less federal funds trading. Trading was thin and the funds rate was usually close to zero, well below Reserve Bank discount rates. Federal funds trading remained low throughout the Depression and World War II but revived after the war. Trading volume rose over time, and by the 1960s the Fed was actively monitoring the federal funds rate to gauge money market conditions. By the 1970s, the FOMC was setting explicit targets for the federal funds rate as part of the conduct of monetary policy.¹⁶ The Fed would then use open-market operations to vary the supply of reserves in the banking system as needed to maintain the funds rate within the desired target range.

The FOMC continues to conduct monetary policy by setting a target range for the federal funds rate. However, the Fed made large-scale asset purchases during the financial crisis of 2008 and subsequent recession (sometimes called the "Great Recession") that greatly increased the quantity of reserves in the banking system. Since then, reserves have remained ample, and the interest rate paid on reserve balances, rather than open-market operations, is now the Fed’s main tool for implementing monetary policy: the Fed adjusts the interest rate on reserve balances up or down to ensure that the federal funds rate stays within the FOMC's target range.¹⁷

Written as of July 2022. See disclaimer.