Federal Funds Rate: CNBC Explains

The federal funds rate is a key element in how banks operate in the U.S. So what is it, and how does it affect the banking system? CNBC explains.

Federal Reserve headquarters in Washington, DC.

What is the federal funds rate?

The federal funds rate is the interest rate at which depository institutions actively trade balances held at the Federal Reserve—called federal funds—with each other.

That's the technical definition — but simply put, it's the interest rate charged by commercial banks to other banks who are borrowing money, usually overnight.

The money they are borrowing comes from what's called the federal funds.

What are federal funds?

These are funds deposited with the Federal Reserve by commercial banks. The funds include money that's in excess of bank reserve requirements— we'll explain those next.

Banks can transfer money from the federal funds among themselves—and be subject to the federal funds rate—or make a transfer from the Fed to themselves on behalf of bank customers on a same-day basis, which is called the discount window.

What are bank reserve requirements?

Reserve requirements are the amount of funds that a depository institution—a commercial bank—must hold in reserve against specified deposit liabilities. This is to make sure banks have enough funds to cover their liabilities. The banks' reserve funds are held by the Federal Reserve.

Please note, this is mostly on paper. No physical money usually changes hands between the banks and the Fed.

The dollar amount of a bank's reserve requirement is determined by applying reserve ratios specified by the Federal Reserve Board to an institution's liabilities. For instance, if a bank has between $11.5 million to $71.0 million in liabilities, it must have funds in the Fed of three percent of the actual total. This is as of December 2011.

Requirement figures have and do change over the years.

How is the federal funds rate set?

The rate is primarily determined by the balance of supply and demand for the funds. But it fluctuates. A target rate is set by the Federal Open Market Committee (FOMC) but the actual rate that's used overnight can be higher or lower, depending on supply of funds and the demand by banks for loans.

What is the difference between the federal funds rate and the discount window?

The federal funds rate is applied only when banks lend to other banks. The discount window is a term, as mentioned above, used when banks borrow money from the Fed for themselves—and not for lending to other banks.

The interest rate charged on such loans by a central bank is called the discount rate, base rate, or repo rate. It is not the federal funds rate.