What is the Federal Funds Rate? Definition, Formula, and Example
The federal funds rate is the overnight interest rate at which U.S. banks lend reserve balances to each other, and it is the Federal Reserve's primary tool for steering the economy.
What is the Federal Funds Rate?
The federal funds rate is the interest rate banks charge each other for overnight loans of reserve balances held at the Federal Reserve. The FOMC does not set the rate directly — it sets a target range (currently expressed in 25-basis-point increments, e.g., 4.25%–4.50%) and uses its policy tools to keep the actual traded rate, the effective federal funds rate (EFFR), inside that range. It is the shortest maturity interest rate in the U.S. financial system and the anchor from which all other borrowing costs — prime rate, credit cards, auto loans, SOFR — are built.
How the Rate Is Determined and Controlled
The EFFR is a volume-weighted median of overnight unsecured reserve transactions reported by banks to the New York Fed, published each morning for the prior day. The Fed keeps the EFFR inside its target range using two administered rates:
- Interest on Reserve Balances (IORB): the rate the Fed pays banks on reserves — the effective floor, since no bank lends below what the Fed pays it risk-free
- Overnight Reverse Repo (ON RRP) rate: the rate the Fed pays non-bank money market participants — a sub-floor capturing cash that would otherwise undercut the range
The discount rate (what the Fed charges banks for direct borrowing) sits above the range as a ceiling. Since 2008's "ample reserves" regime, the Fed steers the rate with these administered rates rather than daily open-market operations.
Worked Example: The 2022–2023 Hiking Cycle
In March 2022, the target range sat at 0.00%–0.25%. Over sixteen months the FOMC raised it to 5.25%–5.50% — eleven hikes totaling 525 basis points, the fastest cycle in four decades. The transmission was mechanical: the prime rate moved from 3.25% to 8.50% in lockstep (prime = fed funds + ~3%), average 30-year mortgage rates went from ~3% to over 7%, and two-year Treasury yields climbed above 5%. Equity markets repriced violently — the S&P 500 fell 25% peak-to-trough in 2022 — while TLT, the long-bond ETF, suffered its worst year on record. Traders tracking fed funds futures saw each hike priced in weeks ahead, which is why the market reactions clustered around Fed *guidance* rather than the hikes themselves.
When Traders Use the Fed Funds Rate
Rate expectations are tradable directly: fed funds futures (CME, contract ZQ) and SOFR futures let traders price the probability of each FOMC outcome. The CME FedWatch tool derives implied hike/cut probabilities from these prices — when futures imply a 70% chance of a cut and the Fed delivers, the market barely moves; the surprise is what trades. Equity traders treat the rate path as the master input for sector rotation: cuts favor rate-sensitive small caps and REITs; hikes favor banks' net interest margins. Options traders price FOMC meetings as discrete volatility events, with the S&P 500's implied move on Fed days running roughly double a normal session.
Limitations and Common Misconceptions
The fed funds rate is an overnight interbank rate — it does not directly set mortgage rates, auto loans, or the 10-year Treasury yield, all of which trade off longer-term expectations and can move opposite to Fed policy (2024 saw the 10-year rise while the Fed cut). "The Fed prints money when it cuts" is wrong — rate changes and balance-sheet policy (QE/QT) are separate tools. And the EFFR's dominance is fading as a transaction benchmark: actual fed funds volumes are thin, and SOFR has replaced it as the reference rate for most derivatives.