Federal Funds Rate: How the Fed's Policy Rate Works

Key Takeaways

• The FOMC sets a target range; IORB and ON RRP administered rates keep the effective fed funds rate inside those bounds.
• Every short-term dollar rate, SOFR, T-bills, money market funds, anchors near the fed funds rate and moves with it.
• A Fed rate cut does not automatically reduce 30-year mortgage rates, which track the 10-year Treasury plus a spread.
• The prime rate is pegged at fed funds plus 300 basis points and moves in lockstep, it is not the same rate.

What It Is

The federal funds rate is the rate charged on unsecured overnight loans of reserves between depository institutions. The Federal Open Market Committee (FOMC) does not fix a single number. It sets a target range, such as 5.25 to 5.50 percent, and then uses administered rates to keep the actual market rate inside that range.

The rate is reported daily in the Federal Reserve's H.15 statistical release as the effective federal funds rate (EFFR), a volume-weighted median of trades in the fed funds market.

The Intuition

Banks settle payments at the end of each day through accounts held at the Fed. Some finish with more reserves than they need, others with less. The fed funds market is where those imbalances clear overnight. Because the Fed can set the price at which banks park reserves at the central bank, it can effectively anchor what banks are willing to accept for lending those reserves to each other.

Every other short-term dollar rate, commercial paper, repo, money market yields, Treasury bills, sits near the fed funds rate because investors have the option to deposit cash at the Fed instead. Move fed funds, and everything priced off the short end moves with it.

How It Works

In the current "ample reserves" framework, the Fed does not actively drain or add reserves every day to hit the target. It uses two administered rates as rails:

• Interest on Reserve Balances (IORB), paid to banks on reserves held at the Fed. IORB sets a floor, because no bank should lend reserves to another bank for less than it can earn risk-free from the Fed.
• Overnight Reverse Repo (ON RRP) rate, available to a wider set of money market funds and dealers. It sets a soft floor for non-banks that cannot earn IORB.

The FOMC statement announces the target range and the Implementation Note specifies the exact IORB and ON RRP rates. The New York Fed's Open Market Desk then keeps the market rate inside the range by adjusting these rails and, if needed, via repo and reverse repo operations.

A simplified version of what gets announced:

Target range:   5.25% to 5.50%
IORB:           5.40%
ON RRP:         5.30%
Primary credit: 5.50%

The effective fed funds rate typically trades a few basis points below IORB.

Worked Example

Assume the FOMC is in a cutting cycle and announces a 25 basis point reduction, moving the target range from 5.25-5.50 to 5.00-5.25 percent. The Implementation Note simultaneously drops IORB from 5.40 to 5.15 and ON RRP from 5.30 to 5.05.

The next morning, the effective fed funds rate prints near 5.12. Repo rates, 1-month Treasury bills, and SOFR all reset lower by roughly 25 basis points within a day. Prime rate, which most US banks set at fed funds plus 300 basis points, moves from 8.50 to 8.25, so new variable-rate credit card, HELOC, and small business loan rates step down.

Longer-dated borrowing does not mechanically follow. A 30-year fixed mortgage is priced off the 10-year Treasury yield plus a spread, and the 10-year reflects expectations for growth and inflation over a decade. If the market already expected the cut, the 10-year may not move at all.

Common Mistakes

1. Confusing it with the prime rate. The prime rate is what banks quote to their best commercial customers. In practice it is pegged at fed funds plus 300 basis points, so it moves in lockstep, but they are not the same number. The fed funds rate is a wholesale interbank rate; prime is a retail lending benchmark.

2. Confusing it with the discount rate. The discount rate, also called the primary credit rate, is charged on direct loans from the Fed's discount window. It sits above the top of the target range and is rarely used except in stress.

3. Assuming fed funds moves translate one-for-one into mortgage and auto loan rates. Short-dated products follow closely. Longer-dated, fixed-rate consumer loans track the Treasury curve plus a credit spread, and that curve reflects inflation expectations, term premium, and global demand for dollar assets. A 50 basis point cut does not mean a 50 basis point drop in 30-year mortgages.

4. Treating the dot plot as a commitment. The FOMC publishes participants' projections for fed funds each quarter. These are individual opinions under current assumptions, not promises. Powell and every other Chair stress that the path is data-dependent.

5. Expecting only 25 basis point moves. The FOMC has moved 50 and even 75 basis points when data warranted, most recently during the 2022 tightening cycle and the 2020 emergency cuts. Assuming a neat quarter-point rhythm can leave you unprepared for a larger step.

Frequently Asked Questions

What is the federal funds rate in simple terms? The federal funds rate is the overnight interest rate US banks charge each other for reserve balances. The FOMC sets a target range for this rate, and it anchors every other short-term dollar borrowing cost in the economy, SOFR, T-bills, and money market fund yields all float near it.

What is the difference between the fed funds rate and the prime rate? The prime rate is what banks charge their best commercial customers, in practice it is pegged at fed funds plus 300 basis points and moves in lockstep. The fed funds rate is a wholesale interbank rate; the prime rate is a retail lending benchmark used for credit cards, HELOCs, and small business loans.

Does a Fed rate cut lower mortgage rates? Not automatically. Short-term products like HELOCs and variable-rate credit cards track the fed funds rate closely. But 30-year fixed mortgages are priced off the 10-year Treasury yield plus a credit spread, driven by long-run growth and inflation expectations, not the overnight policy rate.

What is the IORB rate? Interest on Reserve Balances is the rate the Fed pays banks on deposits held at the central bank. Since no bank should lend reserves to another bank for less than it can earn risk-free at the Fed, IORB sets a practical floor for the effective fed funds rate inside the target range.

What is the FOMC dot plot? The dot plot is a chart of FOMC participants' individual projections for the federal funds rate at year-end for the current and following years. Each dot represents one participant's view under their own economic assumptions, it is not a committee forecast or a promise about future policy, and Powell emphasizes the path is data-dependent.

Sources

1. Federal Reserve Board. "Policy Rate: Economy at a Glance." https://www.federalreserve.gov/economy-at-a-glance-policy-rate.htm
2. Federal Reserve Board. "Monetary Policy: What Are Its Goals? How Does It Work?" https://www.federalreserve.gov/monetarypolicy/monetary-policy-what-are-its-goals-how-does-it-work.htm
3. Federal Reserve Bank of New York. "Monetary Policy Implementation." https://www.newyorkfed.org/markets/domestic-market-operations/monetary-policy-implementation
4. Federal Reserve Board. "H.15 Selected Interest Rates." https://www.federalreserve.gov/releases/h15/

Disclaimer

This article is educational content only and is not financial advice. Nothing here is a recommendation to buy, sell, or hold any security. Consult a licensed advisor before making investment decisions.