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Federal Funds

Posted on October 16, 2025 by user

Federal Funds: Definition and How Loans and Rates Work

Federal funds (or fed funds) are excess reserves that commercial banks and other eligible financial institutions hold at regional Federal Reserve banks. Institutions with surplus reserves lend them overnight to institutions with shortfalls. These loans are unsecured and typically last one day; the interest charged is the federal funds rate (overnight rate).

Key takeaways

  • Federal funds are reserves banks hold above required minimums and lend to one another overnight.
  • The federal funds rate is the overnight interbank interest rate that influences short-term borrowing costs across the economy.
  • The Federal Reserve sets a target or target range, and market activity in the overnight lending market determines the actual effective rate.
  • Open market operations and other Fed tools influence the supply of reserves and therefore the fed funds rate.

How federal funds work

Banks must maintain a certain level of reserves at their regional Federal Reserve banks based on regulatory reserve requirements. When a bank’s deposits and cash positions change during the day, it may end up with either excess reserves or a reserve shortfall. To meet reserve requirements cost-effectively, banks borrow or lend these excess reserves to one another in the fed funds market.

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Because transactions are overnight and unsecured, rates are typically low. The market settles daily, and the weighted average of transactions becomes the effective federal funds rate announced at the end of each trading day.

Reserve requirements and excess reserves

Reserve requirements set the minimum liquid deposits (cash) a bank must hold relative to customer deposits. Amounts held above that minimum are excess reserves. Banks manage these balances to satisfy regulators and internal liquidity controls while minimizing borrowing costs.

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The federal funds rate and monetary policy

The Federal Reserve establishes a target federal funds rate (or range) as a key tool of monetary policy. To influence the actual market rate, the Fed uses open market operations—buying or selling government securities—to increase or decrease the supply of reserves in the banking system. These operations are carried out by the Federal Reserve Bank of New York.

Changes in the fed funds rate affect inflation, economic growth, and employment by influencing other short-term interest rates and borrowing costs for businesses and households.

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Overnight and eurodollar markets

The fed funds market in the U.S. runs parallel to the offshore eurodollar market. Eurodollars are dollar-denominated deposits held outside the U.S., traded overnight, and priced close to the fed funds rate. Multinational banks may book these transactions in offshore branches even if executed in U.S. trading rooms. Both markets are wholesale and often involve large transaction sizes.

Market participants

Participants in the fed funds market include:
* U.S. commercial banks and branches of foreign banks
Savings and loan organizations
Government-sponsored enterprises (e.g., Fannie Mae, Freddie Mac)
* Securities firms and certain federal agencies

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Why it matters

The fed funds market is central to short-term liquidity management for banks and to the implementation of U.S. monetary policy. Movements in the fed funds rate ripple through broader financial markets, affecting short-term benchmarks such as SOFR and influencing borrowing costs for consumers and businesses.

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