The Federal Funds Rate is the rate of interest that is employed when affiliated banks lend money to the Federal Reserve of the United States. The rate is normally applied to very short-term loans that are often repaid the same day of issue or the following business day. Excess fund reserves are the source of the funds used to back the short-term loan to the Federal Reserve.
Extending quick loans using the Fed Funds Rate differs somewhat from the process of lending funds to the consumer market. First, there is a cap on the amount of funds that the bank may lend to the Federal Reserve. This is determined by the current balance of surplus funds in the possession of the bank on a given day. This provision helps to ensure that the bank is not hindered from conducting business, even for a single business day.
Second, there is no qualification process that the Federal Reserve must go through in order to qualify for the short-term loan. It is understood that the loan will be repaid, along with the defined interest rate that makes up the current Federal Funds Rate, within a matter of hours or the following business day at the latest. The defined interest rate is sufficient to handle the small amount of administrative effort required to manage the creation of the loan, transfer of funds, and the posting of the repayment plus interest.
The Federal Funds Rate is reviewed several times per calendar year by a body known as the Federal Reserve Open Market Committee. The purpose of this committee is to ensure that the current Federal Funds Rate is maintained at a level considered to be in the best interests of the economy. To that end, the committee may adjust the rate upward or downward in order to achieve this goal.
Many banks also employ the current Federal Funds Rate when lending resources to other banks affiliated with the Federal Reserve. Often, the duration of the loan is the same as with the Fed's, although the two banks may settle on terms that include a longer repayment period than a calendar day.