Question: What is the Fed Funds Rate?
You always hear about the Fed Funds Rate or the Federal Funds Rate. Just what is it? Glad you asked!
Answer: The Federal funds rate is the rate that banks charge each other for overnight loans. “Why would one bank borrow cash from another?” you ask. The Fed can require banks to keep a certain percentage of assets in the form of cash on hand or deposited in one of the Federal Reserve banks. From time to time, it will establish a required ratio of reserves to deposits; when this ratio is increased, more cash must be kept in the vault at night, making it more difficult (and expensive) for funds to be acquired. When the reserve requirement is lowered, the money supply is loosened; because less cash has to be kept on hand it becomes easier to acquire capital.
The increased (or decreased) cost of acquiring funds is passed on to consumers as banks adjust their prime lending rate (the rate banks charge their best customers) to compensate. The prime lending rate is not uniform; Bank of America may have one rate while U.S. Bank has another. As a result, the most widely quoted prime rate figure in the United States is the one found in the Wall Street Journal. It represents a polling of the nation's thirty largest banks; when twenty-three of those institutions have changed their prime rates, the WSJ responds by updating the published rate. This ultimately affects your bottom line because many credit cards, for example, base the interest rate you pay on a premium above the WSJ prime rate.
