What is the ‘Fed rate’?
When economists, financial journalists, traders etc., are talking about ‘the’ Fed rate, they almost always mean the so-called Federal funds rate. This is the interest banks charge each other for short term loans from the balance they keep at the Federal Reserve, the so-called Federal funds.
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U.S. banks are obligated by law to keep on hand about 10 percent of their outstanding liabilities, either in their vault or at the Federal Reserve. Since banks can’t do anything with these Federal funds, they always try to keep them at the legal minimum. Of course on a day-to-day basis some banks may need extra funds for a short-short-term investment. In such cases banks usually borrow from other banks whose Federal funds balance at that moment is a little more than required. The interest these banks charge each other for such a loan is the Federal funds rate.
Banks can also borrow directly from the Federal Reserve itself. The interest the Fed charges in that case is the so-called discount rate. The discount rate – which is sometimes confused with the Federal funds rate – is usually a little higher than the Federal funds rate, making the latter more popular with banks (no surprise there) and therefore more important.
Now, the Federal Reserve can’t directly set the Federal funds rate, banks do this amongst themselves. The average rate of all those short-term outstanding loans between banks is called the Federal funds effective rate, i.e., the effective rate banks charge each other. ‘The’ intereste rate decision of the Federal Reserve – the one that everybody is so fixated on – is the decision about the Federal funds target rate, i.e., the Federal funds effective rate the Federal Reserve would like to see.
But don’t let the fact that the Fed doesn’t have the power to set the rate directly trick you into thinking it can only hope and pray the banks follow their desired rate, because the Federal Reserve does in fact have a powerful weapon to get its way and have the effective rate move in the direction of the target rate, namely the buying or selling of government bonds on the open market (also known as Open Market Operations).
The mechanism works something like this: when the Fed wants to raise the interest, it sells U.S. treasuries on the open market. Buyers pay for those bonds with dollars, causing the Money Supply to shrink. When there is less money in circulation the cost of acquiring money – i.e., the interest rate – rises. Conversely, when the Fed wants to lower the interest rate, it buys U.S. Treasuries, thus increasing the Money Supply.
