The federal funds rate is the interest rate which is charged by one bank when lending money to another bank. The rate of borrowing is negotiated between the two banks, and a weighted average provides the federal funds rate effective rate.
The members of the federal open market committee meet about eight times a year, at seven weekly intervals. It is their job to set the federal funds target rate. They will also hold additional meetings if necessary to set the federal funds rate, if the target rate changes.
The Federal Reserve can use the open market to influence the amount of money available in the economy. They can do this by buying and selling securities which are government owned. The Federal Reserve has the power to print more money to increase the total amount in circulation.
The law stipulates that banks must retain certain levels of reserves. This can be as cash or as reserves with the Federal Reserve. The amount varies but is typically 10% of the value of the banks checking accounts. If the banks reserve fall below this level then it must raise more funds to comply with the regulations. It can do this by borrowing from another bank at a negotiated federal funds rate.
The nominal federal funds rate is set by the Federal Reserve. This rate is specific, but the federal funds rate lies within a range of the rate. The banks may also borrow from the Federal Reserve through the discount window. The discount window lets them borrow on a short term basis when reserves are temporarily low. The interest rate is typically higher than the federal funds rate, and is called the discount rate.
There may be several different discount rates which are applied to different institutions. These are the primary credit rate and the secondary credit rate. Both are generally offered on an overnight basis. The primary credit rate is the most common, while the secondary credit rate may be used for institutions that are less secure. The third type of rate is the seasonal credit rate, and is offered to institutions on a longer term basis of up to nine months.
Changes to the federal funds target rate affect the whole economy, as many other interest rates move with it. It is used to try to achieve low inflation and stable and sustainable economic growth. Lower rates are used to try to stimulate growth, while higher rates are used to control inflation. For most people the major effect of a change in the federal funds rate will be a change in the interest rate for their mortgage.