In the United States, the federal funds rate is the interest rate at which depository institutions (banks and credit unions) lend reserve balances to other depository institutions overnight, on an uncollateralized basis.
Reserve balances are amounts held at the Federal Reserve to maintain depository institutions’ reserve requirements. Institutions with surplus balances in their accounts lend those balances to institutions in need of larger balances. The federal funds rate is an important benchmark in financial markets.
All American banks are required to park a portion of their deposits with the Federal Reserve in cash, as a statutory requirement.
The US Fed, unlike our RBI, isn’t a single entity. It is a web of institutions made up of a Board of Governors based in Washington, 12 Federal Reserve Banks across key US cities and private banks. Together, the Board and the 12 Federal Reserve banks regulate US lending institutions, act as lenders of last resort and watch out for the interests of depositors.
The FOMC, which decides monetary policy in the US, does not actually ‘fix’ the Fed Funds Rate. What it does, after announcing its target, is to direct open market operations to pull or push this rate into its target range.
The Federal Reserve Bank of New York, the kingpin in the Fed system conducts open market operations to ensure that the Fed Funds Rate behaves itself. To push the rate downwards, it mops up government bonds from the common reserve and infuses cash. The higher liquidity then allows banks to trim their lending rates. To lift this rate, it sells government bonds and vacuums up liquidity from the system.
The Fed Funds Rate is the key indicator of the direction in which US interest rates are heading at any given point in time. If the Fed is hiking rates, lending rates for companies and retail borrowers inch up, and vice versa.
Unlike India’s repo rate, which may not matter much to anyone across the borders, US interest rates matter a lot to global capital flows. A good chunk of the world’s wealthiest investors and institutions have their home in the US. They are therefore constantly comparing interest rates outside the US, to those in their home country, to make their allocation decisions.