Fed Funds Explained No. 5

Impact of the Federal Funds Rate

Popular Misconception

If you start asking questions about federal funds in the federal funds rate, the response you receive will read something like the following:

“The federal funds rate is one of the most important interest rates in the U.S. economy. That’s because it impacts monetary and financial conditions, which in turn have a bearing on critical aspects of the broader economy including employment, growth, and inflation.”

Clipped from Federal Funds Rate: What It Is, How It’s Determined, and Why It’s Important

I don’t mean to pick on Investopedia; I just needed an example of the popular misconception about the Fed funds in the Fed funds rate. Although closely watched by investors and financial analysts, I’m not sure if a lot of them understand the misconception.

The Fed funds market is a closed market in which only account holders at the Federal Reserve Bank can make transactions. Because of the close nature of this market, the interest rate on these funds should not be considered the most important interest rate in the US economy.

Historical Perspective -1983-2008

There was a time when the total bank reserves exceeded the required reserves by only a small amount. These additional reserves were referred to as excess reserves. Banks traded these excess reserves to not fall short of their required reserves, and this market became known as the Fed funds market.

Because of the importance for banks to maintain their required reserves, the interest rate on these Fed funds transactions tended to be a bellwether for market rates. They never were market rates because regular investors cannot trade in these funds, but because of their importance to banks, they tended to move up and down in the same direction, thus giving the impression that they were a significant market rate (which they were not).

A graph showing the price of a stock market

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This chart shows the effective Fed funds rate in the market yield for US treasury securities at five-year maturities. The chart does not present any proof one way or the other as to the connection between the Fed funds rate in an active market rate. I presented simply as an example.

Post Bernanke-2008-recent

Around 2008 Fed Chairman Ben Bernanke had the Fed’s open market committee buy unprecedented quantities of assets held on bank balance sheets. This created excess reserves far beyond the level of required reserves. Since banks had no need to exchange excess reserves, the Fed funds interest rate dropped to near zero. Some of the asset purchases were made from non-bank dealers. This massive infusion of dollars resulted in the market interest rates falling but not by as much as the Fed funds rate.

Because banks no longer needed to acquire excess reserves to cover the reserve requirement, the Fed funds rate lost its status as a bellwether. The chart below indicates the separation between the Fed funds rate and the five-year treasury rate.

Subsequently, the Fed has acknowledged the insignificance of the Fed funds rate and reserve requirements by eliminating reserve requirements altogether. The correlation between The Fed funds rate and market rates has not broken down entirely because people still believe in the misconception of the connection between the Fed funds rate and market interest rates.

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Investors, politicians, and interested parties, should ignore any talk about the Fed funds rate. Fed funds are bought and sold in a closed market, they do not provide a source of financing for banks, and the interest rate charged on these funds is only a loose tie to general market rates.

A great deal of other interest rate data is available, which, coupled with monetary data, gives a much better indication of what’s happening in financial markets than the Fed Funds Rate.


July 27, 2023 — The Federal Reserve met today to announce that they will “raise rates 25 basis points.” Big deal.

If you want some data to keep your eye on, look at this:

A graph showing the growth of the stock market

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After explosive growth of the money supply (and you wonder why we have inflation), the money supply is now on the decline. We have price distortion on the way up. Will we have price distortion on the way down?

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