The Fed Funds Market

Fed Funds are funds which banks lend each other on an overnight basis to meet the Fed’s reserve requirements. (Most banks must hold cash reserves equivalent to 10% of their transaction deposits, but day-to-day reserves fluctuate based on transactions activities.   Contrary to popular belief, the Fed does not actually set the Fed Funds rate.  But it has great influence upon it through its open market operations.  For example, if the Fed buys government securities (e.g. Treasuries) from dealers in the open market, the Fed will make payment by adding reserves to the banks where the dealers deposit their funds. This operation increases the supply of bank reserves, pushing down the yield on Fed Funds loans.  Similarly, if the Fed sells securities it will secure payment by reducing reserves of the banking system, putting upward pressure on the Fed Funds rate.When the Fed announces its monetary policy objectives, it sets a target for the Fed Funds rate.  In then engages in daily open market operations to achieve that target. If you follow the markets, you will notice that the Fed Funds rate fluctuates quite a bit around the target (currently 1.25%) on a daily basis.The main point here is that the Fed Funds rate is a market rate determined by the demand and supply of overnight Fed Funds loans between banks. You might say, however, that the Fed “owns” (and thus has ultimate control over) this market since the market is created because the Fed maintains bank reserve requirements.

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