The Federal Funds Rate

The federal funds rate is the interest rate at which financial institutions lend each other money through the mechanism of the Federal Reserve. We all know that the Fed “sets” the federal funds rate. But according to this Wikipedia article, the Fed can only set a target for the rate. Apparently the financial institutions are free to negotiate any mutually agreeable rate.

How, then, can the Fed really influence interest rates? In other words, why would banks agree to something other than the market-clearing interest rate just because the Fed wants them to? Also, supposing there is some way the Fed can coerce banks to do business only at the Fed’s target rate, if the Fed’s target is different from the market-clearing interest rate, wouldn’t this depress the money supply by discouraging lending? In other words, I have a trillion dollars on deposit at the Fed, but I don’t want to lend it at the Federal Funds Rate. So I just sit on it and hope that the rate will go up, or I use it for some other, more profitable purpose.

The Discount Rate.

Thanks, but this didn’t help me.

Sorry. The discount rate is the rate at which member banks borrow from the Fed. If the discount rate goes up, the cost of borrowing goes up, and this causes the banks to be more cautious: they are more reluctant to lend because they don’t want to have to borrow. So there is less overnight money out there for inter-bank borrowing; the supply of funds is restricted, so the price, the Federal Funds Rate, goes up.

If you had loanable money available to a member bank, but won’t lend it, then they will go to another bank. If they can’t get elsewhere, they’ll have to offer a price you’ll accept. The problem is that you’ll be giving up profits by refusing to lend money.

Does that help?

Yes, thanks. I had the Federal Funds rate confused with the discount rate.

This leads to a related question: Does the Fed make money off the discount rate? I know the Fed does not turn a profit, but it seems that the interest it earns on lending to banks is a source of revenue nonetheless. How important is this revenue? In the news, you always hear about the Fed changing the discount rate, but it seems like the Fed only considers the impact on the money supply when it changes the discount rate, not the impact on its revenue from lending to banks. Also, where does this revenue go?

That is something I do not know. Sorry.

The fed targets the rate mostly through its open market operations. The FOMC buys or sells US Treasury securities as a means of increasing or decreasing the money supply.

Banks hold reserve funds in accounts at the Fed. They will lend or borrow Fed Funds depending on where they are relative to their desired or required balances at the Fed. So when the Fed wants to raise that Fed funds rate (the cost of holding money), it needs to reduce the supply or increase the demand for available balances. It does so by selling Treasuries.

Example: E-Diddy has an account at Bank of America with $1 million. The Fed is selling securities and I decide to buy $1 million worth. Bank of America debits my account for $1 million. And the Fed in turn debits B of A’s Fed account for $1 million. B of A now has less money in reserve. If they were planning on lending that $1 million through Fed funds overnight, forget about it, they can’t spare it. And if they were already short of their desired balances, they are now even more short, meaning that they will have to borrow additional funds.

You do that on a large enough scale and all of a sudden lots more banks need overnight cash and fewer banks have the overnight cash to lend. The end result is that the rate goes up. The Fed can adjust its purchases every day if things get a bit out of balance.

In news reports, the discount rate is referred to as largely symbolic. The key rate is really the Fed Funds rate and that is manipulated through open market operations, as E-Diddy described. More details:

As for your other questions, yes, the Fed makes money. For example, it buys treasury bonds off of the market (thereby releasing money into the banking system). The treasuries earn interest. After the expenses of running the Fed are taken out, the excess is turned over the Federal Government.

As this excess dwarfs the expenses of running the Federal Reserve, they don’t give this issue too much thought.