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I'm trying to understand the "Fed interest rate".

Wikipedia says:

"Financial institutions are obligated by law to maintain certain levels of reserves... The bank can borrow the requisite funds from another bank that has a surplus in its account with the Fed. The interest rate that the borrowing bank pays to the lending bank is negotiated between the two banks. The weighted average of this rate across all such transactions is the federal funds effective rate."

So, the banks lend to each other, and the interest rate they negotiate. Seems like the interest rate can be any. How does it depend on the Fed's interest rate?

"The federal funds target rate is set by the governors of the Federal Reserve, which they enforce by open market operations and adjustments in the interest rate on reserves. The target rate is almost always what is meant by the media referring to the Federal Reserve "changing interest rates." The actual federal funds rate generally lies within a range of that target rate, as the Federal Reserve cannot set an exact value through open market operations."

What does this exactly mean? What is the "target" rate, and why do the banks care about it at all?

  • Can you clarify where you're confused - you start with "Fed interest rate" - but mention the overnight funds rate and the target rate. Are you confused about the differences between those two or which one "Fed interest rate" refers to? – D Stanley Mar 5 at 17:26
  • I would like to understand the mechanism Fed uses to control the interest rate. How do they do that? If it's "negotiated between the two banks", it can be any, yet it isn't, Fed somehow limits it. – Danijel Mar 6 at 13:40
  • It's like car prices. They are "negotiated" between the buyer and seller based on actual borrowings, so it can't just be made up - it has to be something that is agreed to by both parties. If the given answer doesn't help then add any clarifying questions to your post. – D Stanley Mar 6 at 14:34
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The Federal Bank has control over how much money is actually lent out to financial institutions in the form of federal reserve. This amount is adjusted to closely match the Federal target interest rate. Banks lend to each other overnight at competitive rates, because it's easy enough to call up and negotiate with a different bank that has excess reserves at a more favorable rate. The demand for acquiring excess is what drives the exchange rate.

As an example, if the Fed Chairman announces a target interest rate of 0%, this would effectively mean that the Federal Bank is freely lending out so much supply in federal reserve notes that the banks have zero demand to borrow reserve from each other. They would all simply be borrowing more reserves from the Federal Bank.

The Federal Bank also controls the Fed Window, which is a lender of last resort for overnight reserves if no other banks will exchange their own reserves. This typically would only be needed if all of the banks are worried about meeting capital requirements.

Banks do not specifically profit form the rate itself. The actual rate does drive other factors related to lending, capital requirements, monetary policy, and the overall economy on a macro level. It is in the banks' own interest to weather out periods of economic weakness, and it's between them and their regulators on how stringent they are with their lending requirements, and how much they leverage their fractional reserves.

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