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Fed Funds Rate & Effective Fed Funds Rate Thumbnail

Fed Funds Rate & Effective Fed Funds Rate

Ethan Kent

The Federal Reserve (the Fed) controls monetary policy in the US, seeking a balance between maximum employment and stable inflation. To achieve this, the Fed sets a target range for the Federal Funds Rate (FFR). This dictates the Effective Federal Funds Rate (EFFR), which is the rate at which banks lend to each other overnight. Other interest rates, like those of short-term instruments, consumer loans, bond yields, and business loans depend on the FFR. These rates carry significant implications for the economy. 

The Fed establishes the FFR and uses tools that drain or inject reserves from the banking system. Banks depend on each other for short-term loans and require reserves to operate.  As the Fed drains reserves from the system, there is less supply, so the cost of reserves increases. Banks will not accept returns lower than their cost of borrowing, so as costs increase, banks pass their costs off to consumers demanding higher rates/returns from mortgages, auto-loans, and the like. In contrast, an injection of reserves increases the supply, so borrowing costs decrease and, consequently, consumer rates can also decline.

The Fed sets a floor and a ceiling for the FFR. The floor is the minimum interest rate banks can earn by leaving their money at the Fed. If the Fed raises this floor, banks can make more money risk-free at the Fed, so they will only lend to others at even higher rates. If the Fed lowers the floor, banks earn less at the Fed and are willing to accept lower rates elsewhere. The ceiling is the high-interest rate banks must pay if they borrow money directly from the Fed. This option is more expensive, so banks are more inclined to borrow among each other instead. The effective federal funds rate (EFFR), which we’ll refer to as the overnight lending rate from now on, settles between the floor and the ceiling depending on the availability of reserves in the system.

Short-Term Rates

Short-term money refers to very safe, easy-to-use assets that can quickly be turned into cash. When the overnight lending rate goes up, short-term money borrowing costs rise too. One of the first places this happens is in repurchase agreements, or “repos,” which are overnight loans backed by safe assets like U.S. Treasuries. The Fed helps control these rates by setting a “floor,” which comes from the interest rate the Fed itself pays on reverse repos (where investors lend cash to the Fed and receive Treasuries as collateral). When the Fed raises their reverse repo rate, financial institutions can earn more money risk-free by lending there. Subsequently, other entities who issue reverse repos must raise their own reverse repo rates to compete with the Fed and attract funding. Because banks, hedge funds, and money market funds use repos (lend money in exchange for treasuries) every day, these short-term rates are reflected almost immediately when the Fed changes its target.

Treasury bills (T-bills) are short-term government bonds (0–1 year maturity), and their rates follow those of repos. For example, if using a repo yields 5.5% and existing T-bills are 5.3%, investors will close their T-bill positions and use repos. As T-bills are sold off, their prices will decrease and their yields will increase, bringing their rate closer to equilibrium with repos. Issued by the Fed, the very next T-bill auction will have higher yields because bidders demand compensation that matches the new short-term rate environment. Repos form the foundation of short-term rates, with T-bills sitting just above them in the risk hierarchy.

Long-Term Rates

Treasury notes (2–10 year maturity) and Treasury bonds (20–30 year maturity) also reflect the higher cost of borrowing. They move with short-term rates but do so more gradually as investors factor in expectations about future interest rates, inflation, and economic conditions over time. As mentioned in the earlier T-bill example, bond prices and rates are inverse: as rates go up, prices drop. If short-term rates go up, and consequently their value goes down, T-note and T-bond holders might wait years for rates to drop instead of selling their position at a loss.  Over time, if higher short-term rates persist, investors may gradually sell more and buy less T-notes and T-bonds.  With less demand, their prices may decline, and rates may rise. As longer-term Treasury instruments’ yield increases, businesses and other entities seeking longer-term funding via bonds will have to provide increased yields to remain competitive.

Other Rates

As short-term rates climb, so do other benchmarks like commercial paper rates, bank prime rates, and adjustable-rate loans. The commercial paper rate is the cost for companies to borrow money from banks over a very short period (less than 270 days), the bank prime rate is the rate at which banks loan to their most creditworthy customers (typically businesses), and adjustable-rate loans typically refer to things like mortgages and credit cards. Banks increased cost of borrowing is passed on to consumers and businesses in the form of increased interest on loans, which results in less spending, growth, and activity throughout the economy.

The Big Picture

Higher interest rates constrict economic activity. If consumers face higher mortgage and loan payments, their overall spending tends to decrease. Additionally, businesses faced with elevated borrowing costs may postpone or downscale capital expenditures and other expansion plans, subsequently constricting employment. Collectively, these behaviors slow economic growth but keep inflation at bay. Conversely, when the Fed lowers the FFR target range, the process reverses. Rates fall and borrowing becomes cheaper. This encourages investment and spending, stimulating economic growth while potentially exacerbating inflation.

The Fed’s policies carry influence beyond the US and into the global economy. No matter where you live, the Fed’s interest rate adjustments can affect the yield on your savings and fixed-income investments, and the overall performance of your portfolio. Understanding how these changes flow through global markets can help you make informed decisions about saving, borrowing, and investing.

For more information on how the Fed, FFR, and EFFR can affect your personal finances, please reach out to one of our wealth planners.


 This material is intended for educational and informational purposes only. It is not intended to provide specific advice or recommendations for any individual. Additionally, you should consult with your Financial Advisor, Tax Advisor, or Attorney on your specific situation. The views expressed in the material are that of the author and do not necessarily reflect those of any market, regulatory body, State or Federal Agency, or Association. All efforts have been made to report or share true and accurate information. However, the information may become materially outdated or otherwise rendered incorrect due to subsequent new research or other changes, without notice. The author nor the firm are able to always verify the content from third-party sources. For additional information about the firm, please visit the MAS Website at https://www.mas.gov.sg/  and the SEC Website at www.adviserinfo.sec.gov. For a copy of the firm's ADV Part 2 Brochure, please contact us at info@avriowealth.com.