Federal Funds Target Rate
Chart of the Week for September 21 - September 27, 2007
Banks in the United States are legally obligated to keep a portion of deposits with the Federal Reserve or on hand in cash. This amount is held as the reserve amount and represents a percentage of total bank deposits. If banks fall below the reserve requirements they are required to borrow money from other banks, or the Federal Reserve in order to meet the minimum reserve value. The Federal Reserve plays a vital economic role by setting the federal funds rate. The federal funds rate is a benchmark interest rate for loans from banks with excess reserves to banks needing overnight loans to meet reserve requirements. The federal funds rate is also a factor utilized by many finanical institutions for setting their interest rates. Approximately every six weeks, the Federal Open Market Committee (FOMC), led by Federal Reserve Chairman Ben Bernanke, meets to determine the necessary changes to the target level of the federal funds rate. Before the FOMC makes changes to the federal funds rate, it evaluates the strength of the economy using various economic indicators and market research.
Changes in the federal funds rate impacts market interest rates, in turn, affecting business and consumer spending, inflation, and overall economic growth. An increase in the federal funds rate is generally considered "restrictive monetary policy" as it tends to increase the cost of borrowing and discourages lending. On the other hand, a decrease in the federal funds rate may be seen as an "expansionary monetary policy" as banks are able to borrow at lower rates which encourages borrowing and lending.
The graph above highlights the changes in the federal funds rate over the previous twenty years with the areas in blue representing the months the FOMC lowered the target federal funds rate. On Tuesday this week, the FOMC voted unanimously to lower the federal funds rate 0.50% to a target rate of 4.75%, which was the first rate cut since 2003. According to FOMC statement, the committee's decision to lower the rate was based on the continuing uncertainty of credit conditions and was "intended to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruption in the financial markets." According to Moody's Economy.com analysts, the FOMC left room for future rate cuts at their next meeting at the end of October with any future monetary policy changes dependent on incoming economic data over the next six weeks.
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