An American flag hangs outside the Federal Reserve Bank of New York. Image source: iStock/Thinkstock.
There are multiple interest rate benchmarks in the United States, but none is more important than the fed funds rate. This is the rate banks charge each other to borrow money on an overnight basis. It's also the tool used by the Federal Reserve to influence monetary policy.
A primer on the fed funds rate
Banks are required by law to keep a certain amount of money in cash or on deposit at their regional branch of the Federal Reserve. This helps ensure that banks can satisfy customer requests to withdraw money from their checking and savings accounts.
Some banks go even further, holding more reserves than they're required to under the rules and regulations that govern the bank industry. These are known as excess reserves, and they're what the fed funds rate impacts directly.
Data source: Federal Reserve Bank of St. Louis. Chart by author.
When one bank holds excess reserves and another bank doesn't have enough reserves to meet its legal obligation, the first bank will lend a portion of its excess to the second bank on an overnight, unsecured basis. The fed funds rate is the interest rate charged by the first bank to do so.
Generally speaking, the fed funds rate is the lowest interest rate in the economy. In the wake of the financial crisis, between 2009 and 2015, it hovered just above 0%. It then began to move higher in Dec. 2015, though it's still less than 50 basis points, or half a percent.
Why the fed funds rate matters
The importance of the fed funds rate extends beyond the fact that it impacts how much one bank is charged to borrow another bank's excess reserves. This is because the Federal Reserve uses the fed funds rate to set monetary policy.
Let's say that the Fed wants to drive down the unemployment rate, which is one of its two Congressional mandates, the other being to keep inflation in check. To do so, the Fed drives down the fed funds rate by buying securities from banks. This boosts the supply of bank reserves and thereby lowers their price, the fed funds rate.
This encourages banks to find other places to put their money to work, lest it sit fallow on their balance sheets earning next to nothing. One way for banks to put their money to work is by lending it out to people who want to buy houses as well as to businesses that are making investments to grow, both of which spur the economy.
Data source: YCharts.com. Chart by author.
On top of this, banks use the fed funds rate as a benchmark to set other interest rates. After the Federal Reserve increased the target fed funds rate in Dec. 2016, for instance, all of the nation's biggest banks immediately raised their prime lending rates -- the rates at which they lend to the most creditworthy customers, typically multinational corporations.
The fed funds rate doesn't just have an impact on the price that banks pay to borrow money from each other, in other words. It also directly impacts the interest rate on your mortgage, home equity loan, or car loan, as well as the interest rate that businesses pay to borrow money in order to expand.
This is why it's important to understand what the fed funds rate is, even if you don't work at a bank or in the financial industry.
