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The Federal Reserve System implements monetary policy largely by targeting the federal funds rate. This is the interest rate that banks charge each other for overnight loans of federal funds, which are the reserves held by banks at the Fed. 

What's the Federal Fund Rate?

The federal fund rate is actually determined by the market and is not explicitly mandated by the Fed. The Fed therefore tries to align the effective federal funds rate with the targeted rate by adding or subtracting from the money supply through open market operations. 

The Federal Reserve System usually adjusts the federal funds rate target by 0.25% or 0.50% at a time.

Fed Chair Powell announced a robust updating of the Fed's monetary policy framework during his virtual speech at the Jackson Hole Symposium on August 27th 2020. The Fed's new approach could be viewed as a flexible form of average inflation targeting, allowing inflation to run moderately above or below the Fed's 2% target for some time.

This means that interest rates could be left lower for a longer period despite a rise in inflation.

Why the Federal Funds Rate matters?

The federal funds rate is one of the most important interest rates in the U.S. economy since it affects monetary and financial conditions, which in turn have a bearing on critical aspects of the broader economy including employment, growth, and inflation. 

The rate also influences short-term interest rates, albeit indirectly, for everything from home and auto loans to credit cards, as lenders often set their rates based on the prime lending rate. The prime rate is the rate banks charge their most creditworthy borrowers and is influenced by the federal funds rate, as well.

Investors keep a close watch on the federal funds rate, too. The stock market typically reacts very strongly to changes in the target rate. For example, even a small decline in the rate can prompt the market to leap higher as the borrowing costs for companies gets lower.

Companies looking to borrow and expand their businesses face higher borrowing costs when the Fed raises rates. Johnson says this can drive stock prices down because higher borrowing costs lower corporate profit margins.

Many stock analysts pay particular attention to statements by members of the FOMC to try to get a sense of where the target rate might be headed.

The update news about Federal Funds Rate

The Federal Reserve has left the target range for its federal funds rate unchanged at 0-0.25 percent on July 29th, 2020 but opened the door for further monetary easing to support the world's largest economy through the pandemic.

Federal Reserve Vice Chair Richard Clarida left open the possibility of employing Treasury yield caps at some point in the future, though he indicated it’s not likely now and reiterated the central bank’s rejection of negative interest rates.

Yield caps and targets were not warranted in the current environment but should remain an option that the committee could reassess in the future if circumstances changed markedly.

-Federal Reserve Vice Chair Richard Clarida

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