Fed funds rate

The Fed funds rate is the interest rate at which U.S. banks lend money to each other overnight. The rate is determined by market forces, but the Federal Open Market Committee (FOMC), the Fed's monetary policy committee, sets it as a target and then maintains it via the sale and repurchase of Treasury securities (this is called "open market operations"). So while at any given time the market rate may be slightly higher or lower than the actual fed funds rate, it is common to refer to them as the same thing, because the Fed has essentially unlimited power to operate in the market and move the rate toward its target, and since the market knows this it is a bit of a self-fulfilling prophecy. The FOMC can decide to change the rate at any time, but it meets regularly eight times a year to formally reconsider the level of the rate. The financial and investment community watches these meetings, understandably, with great interest.

What does it mean if the Fed raises or lowers the fed funds rate? The rate acts as a formal or de facto benchmark for most short-term interest rates, so these will move more or less in lockstep with the fed funds rate: 6-month CDs, credit card rates, T-Bills, etc. Longer-dated securities like IMM Eurodollar futures and Treasury Bonds will also be affected, but much less so because they are much further down the yield curve, and short-term rates are only weakly dependent on long term rates. In that sense moving the rate (say) down from f1 to f2 is like tugging at one end of a string, e.g.:

        |              --------=========
        |      ..----  -------'
        |  ..        .
      f1|/      .---
      | |    .-
rate  | |  .
      | | .
      v |/
      f2|
        |
        |
        +---------------------------------
        O/N 1y 2y  5y    10y           30y
 
                  maturity

Changing the rate, along with the open market operations that are used to support it, is the Fed's basic instrument of monetary policy: lower rates are stimulatory and encourage growth (consumers face less interest on consumer debt and are encouraged to spend more, and businesses are better able to borrow, or pay back floating rate debt), and higher rates "cool down" the economy by slowing growth.