Federal Funds
Candlefocus EditorFederal funds, also known as bank funds or federal reserve funds, refer to the excess reserves held by financial institutions. This can include savings accounts, checking accounts, or other financial instruments. Banks will often choose to keep excess reserves over and above the reserve requirements mandated by the central bank as a way to maintain liquidity and provide themselves with a margin of safety.
On an overnight basis, banks that find themselves with excess reserves on hand will often lend them to other banks. This borrowing of funds between banks allows those that find themselves short on the reserve requirements to bring them back up to the mandated level. In turn, this inter-bank market allows those banks with excess reserves to put them to use and earn a modest return.
The rate associated with interbank lending is called the federal funds rate. This rate is set by the central bank as a target and is typically used as a form of monetary policy. The actual interest rate that each bank will receive or pay in the market will vary but is generally close to the target rate. Excess liquidity in the banking system tends to drive the rate down, while tightness in the system will push the rate up towards the target.
Federal funds play an important role in the broader economy. This inter-bank market is highly liquid, allowing banks to quickly buy and sell funds as needed. This short-term borrowing of funds is an efficient means of meeting reserve requirements and maintaining liquidity in the banking system. Furthermore, the federal funds rate is a key tool in terms of monetary policy, providing a gauge of the tightness of the money supply. In this way, the federal funds market and rate help provide financial institutions with safety and flexibility, while also helping to promote stability in the broader economy.