How The Federal Funds Rate Is Steered

Coverage of American monetary policy describes the Federal Reserve as setting interest rates. What it sets is a target range, and the market rate is steered into it by other means.

What the rate actually is

The federal funds rate is the rate at which certain institutions lend reserve balances to one another overnight, without collateral.

It is a market rate produced by actual transactions, and the published figure is a volume-weighted measure of what those transactions cost.

Because it is a market rate, no committee can simply declare it. The announced target range describes where policymakers intend that market rate to settle.

The floor that does most of the work

Banks holding reserve balances at the Federal Reserve are paid interest on those balances, which establishes a rate they can earn without any counterparty risk.

A bank has little reason to lend reserves elsewhere below that rate, so the administered rate acts as a floor beneath overnight lending.

Adjusting the administered rate therefore moves the whole overnight market, which is why policy changes propagate without the central bank trading at all.

Why a second facility exists

Some participants in the overnight market cannot hold reserve balances or earn interest on them, including certain money market funds and government-sponsored entities.

A separate overnight facility allows those participants to lend to the Federal Reserve against collateral at a stated rate, extending the floor to institutions the first tool misses.

Without it, those participants would lend below the administered rate and pull the market rate beneath the target range.

How the range transmits outward

The overnight rate anchors the front end of the yield curve, and longer rates reflect expectations about where the overnight rate will be over time.

Because long-term borrowing costs depend on those expectations, communication about the likely path of policy matters as much as any individual adjustment.

This is why statements and projections receive as much market attention as the decision itself, and why rates can move well before any change is made.

What the framework does not control

Mortgage rates, corporate borrowing costs and deposit rates are set by separate markets and institutions that respond to policy without being determined by it.

The transmission is indirect and operates with lags that vary by channel, which is why the effects of a policy change appear unevenly across the economy.

Policy decisions, meeting materials and the operating framework are published by the Federal Reserve, which is the authoritative source rather than any secondhand description.