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What are Federal Funds?

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  • Written By: Mary McMahon
  • Edited By: Kristen Osborne
  • Last Modified Date: 23 January 2020
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In the United States, federal funds are monies put on deposit with the Federal Reserve in order to meet reserve requirements. Banks with more money on deposit than they need to meet their requirements can choose to lend to institutions with a fund shortage, charging interest on the loan. The interest charged is known as the federal funds rate, and usually the Federal Reserve sets a target rate with the goal of developing strong monetary policy in the United States.

Under the Federal Reserve system, banks are required to keep a fraction of their deposits on hand with the Federal Reserve. This is intended to address concerns about bank panics and to make sure that banks are operating with enough money to function. Banks with less than their reserve requirement on deposit are a cause for concern, as they may not be able to meet demands for withdrawals, wire transfers, and other banking activities.

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At the end of each day, banks determine how much they need to have on deposit. Banks with deposits that fall short can access loans of federal funds through banks with extra money on hand. This relationship benefits both banks. The excess deposits can be put to profitable use instead of sitting in a vault, and banks with a temporary funds shortage can access money. These loans are usually made overnight, although longer terms are also available. A temporary shortfall in funds made up with borrowed federal funds is less of a cause for concern than a chronic underfunding problem.

The federal funds rate tends to be tracked by economists, as well as members of the investing community. Rises and falls can correspond with a tightening of credit or a growing economy. When less money is available, interest goes up. This can create a ripple effect, making it harder to loan money and slowing financial activities, many of which are based on credit. When the interest rate is low, there's plenty of money available and banks make loans readily.

Information on the latest federal funds rate can be obtained through financial publications, as well as the Federal Reserve itself, for people who are curious. It may also be called the overnight rate, referencing the idea that it applies to loans made overnight. People should be aware that commercial interest rates, such as those on mortgages and credit cards, tend to be higher than the federal funds rate.

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