fbpx
October 23, 2014 Reading Time: 2 minutes

It drives me nuts when people say the Federal Reserve sets the interest rate. Ditto for claims that the Fed raises or lowers the rate. Basically, any mention of rate setting by the Fed causes the whistle in my head to blow, as steam pours out from my ears. (Unless, of course, they are referring to loans made by the Federal Reserve… but they almost never are.)

These claims are usually in reference to the federal funds rate, the interest rate at which a depository institution charges another for borrowing funds held at the Fed. Such funds are called federal funds—hence the name. These loans are usually for very short durations—overnight—and, as such, the federal funds rate is occasionally referred to as the overnight rate.

Does the Fed set this rate? No. This rate is agreed upon by the institutions borrowing and lending overnight in the federal funds market. In fact, it is technically incorrect to refer to the federal funds rate since, on any given day, there is a range of rates being charged.

The Federal Reserve Bank of New York collects data on the federal funds market. I’ve charted this data for the last month. The grey boxes mark the daily effective federal funds rate as a volume-weighted average of rates on trades arranged by major brokers. The vertical bands depict the range of rates prevailing on that day.

chart

The Fed does not set the federal funds rate. Rather, it sets its federal funds rate target. The distinction is important. Whereas setting the rate implies that the Fed directly determines the rate, setting the target makes clear that the Fed is merely conducting monetary policy in reference to the rate. If the rate is above the Fed’s target, for example, it will increase asset purchases, thereby increasing the rate of money growth.

To be sure, Fed policy affects interest rates. According to the Fisher equation, nominal rates equal real rates plus expected inflation, the latter of which depends in large part on the expected growth rate of money. And the Fed might even affect real rates in the short run through the portfolio and/or first-round loanable funds effects. Jeffery Rogers Hummel provides an excellent overview of these issues.

The point here is that the Fed does not set the federal funds rate. It sets its federal funds rate target. Recognizing this distinction is perhaps the first step towards a sophisticated understanding of what the Fed does when conducting monetary policy.

William J. Luther

William J. Luther

William J. Luther is the Director of AIER’s Sound Money Project and an Associate Professor of Economics at Florida Atlantic University. His research focuses primarily on questions of currency acceptance. He has published articles in leading scholarly journals, including Journal of Economic Behavior & Organization, Economic Inquiry, Journal of Institutional Economics, Public Choice, and Quarterly Review of Economics and Finance. His popular writings have appeared in The Economist, Forbes, and U.S. News & World Report. His work has been featured by major media outlets, including NPR, Wall Street Journal, The Guardian, TIME Magazine, National Review, Fox Nation, and VICE News.

Luther earned his M.A. and Ph.D. in Economics at George Mason University and his B.A. in Economics at Capital University. He was an AIER Summer Fellowship Program participant in 2010 and 2011.

Books by William J. Luther

Get notified of new articles from William J. Luther and AIER.
AIER - American Institute for Economic Research

250 Division Street | PO Box 1000
Great Barrington, MA 01230-1000

Contact AIER
Telephone: 1-888-528-1216 | Fax: 1-413-528-0103

Press and other media outlets contact
888-528-1216
[email protected]

Editorial Policy

This work is licensed under a 
Creative Commons Attribution 4.0 International License,
except where copyright is otherwise reserved.

© 2021 American Institute for Economic Research
Privacy Policy

AIER is a 501(c)(3) Nonprofit
registered in the US under EIN: 04-2121305