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The Federal Funds Rate: The Fed's Primary Tool, Explained

Macro and the Federal Reserve • Beginner Investing • 7 min

What this lesson is about

One overnight bank-to-bank lending rate, quietly rippling out to mortgages, credit cards, and savings accounts across the entire economy.

2 parts · a quick check after each · then the quiz

Part 1 of 2

The federal funds rate is the interest rate banks charge each other for overnight loans of reserves. Most people won’t borrow or lend at this rate directly. Yet, it shapes mortgage rates, credit card rates, savings account yields, and borrowing costs across the economy. Since December 2008, the Fed sets this as a target range (like 5.25%, 5.50%) instead of one fixed number. This shift happened during the emergency rate cuts of the 2008 financial crisis.

The link from this overnight interbank rate to the rates you see occurs because banks' cost of funds changes with the fed funds rate. When their borrowing costs rise or fall, they adjust the rates they charge you and businesses. A higher fed funds rate target usually means higher rates on new mortgages, auto loans, and credit card balances. It also tends to push savings account and CD yields a bit higher.

The money marketDrag the supply line. The rate is wherever it crosses demand.

Quick check

What is the federal funds rate, in its most literal, technical sense?

Part 2 of 2

Insider Angle: Keeping the real-world market rate within the Fed's target range needs technical machinery most people don’t hear about: interest on reserve balances (IORB). This is the rate the Fed pays banks on reserves parked there. The overnight reverse repo (ON RRP) facility allows a broader set of financial institutions to park cash overnight at the Fed too. Together, these create what's called a "floor system." By controlling what banks and other institutions can earn risk-free by leaving money at the Fed, these tools effectively set a floor for the real market federal funds rate. This lets the Fed keep the actual rate within its announced target range without having to buy or sell securities every day just to hit the number.
Try This: Look up the Fed's current federal funds rate target range. Then check the average rate on a 30-year mortgage or a savings account. Compare each historically to where it has sat relative to the fed funds rate.

Quick check

Since December 2008, how does the Fed typically express its federal funds rate target?

Quiz

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