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The Basics of the U.S. Federal Funds Rate: A Guide

Overview

The Federal Reserve System, or simply the Fed, is the central bank of the United States and provides the nation with a safe, flexible, and stable monetary and financial system.


The objective of the Fed is to promote the effective operation of the U.S. economy and to serve the public interest. It includes three key entities: the Board of Governors, 12 Federal Reserve Banks spread across the U.S., and the Federal Open Market Committee, also known as the “FOMC”, which is the policymaking body of the Fed that meets eight times a year to set monetary policy.


What is the “fed funds rate” and why is important?

The term Federal Funds Rate, also known as the fed funds rate, refers to the Target Interest Rate Range set by the FOMC. This target is the rate at which commercial banks borrow and lend to each other their excess reserves within the Federal Reserve System.


By law, financial institutions (mostly banks in this case) are required to maintain accounts at Federal Reserve banks to ensure they have enough money to cover depositors' withdrawals and other obligations. Any money in their reserves that exceeds a predetermined required level are available for lending to other banks that might have a shortfall.


The Fed uses the federal funds rate to control U.S. money supply and influence the cost of credit throughout the economy. This rate is important because it influences other interest rates in the economy, such as the rates for mortgages, savings accounts, and personal loans.


How is the Federal Funds Rate determined?

The Federal Open Market Committee (FOMC) meets eight times a year to set the Target Federal Funds Rate based on key economic indicators that may show signs of inflation, recession, or other issues that can affect sustainable economic growth. This is the “suggested” interest rates that lending banks can charge borrowing banks within the federal reserve system. However, the Fed cannot force banks to charge the EXACT federal funds rate; thus, the FOMC sets a target rate as a guidepost.


The actual interest rate a lending bank will charge is determined through negotiations between the two banks. The weighted average of interest rates across all transactions of this type during a defined period is known as the Effective Federal Funds Rate.


What Are Fed Funds Futures Contracts?

Fed funds futures contracts are financial futures contracts based on the Federal Funds Rate and are negotiated on the Chicago Mercantile Exchange (CME).


As the shortest-term risk-free interest rate, the federal funds rate sets the floor for other interest rates throughout the economy. Increases in the fed funds rate raise borrowing costs for a wide variety of new and variable-rate loans and drive-up bond yields. Conversely, when the fed funds rate drops, other interest rates tend to decline as well. Lower interest rates promote faster economic growth, while higher ones often slow it.


The prices of fed funds futures contracts reflect market expectations about future changes in the Fed Funds Rate based on the target ranges the Fed sets as one of the tools to implement monetary policy.


Contract Specifications and Example

As mentioned, futures contracts are negotiated at the CME and called “30-day fed fund futures contracts”. They are listed for 60 consecutive months and cash settled on the first business day following the last trading day. The contract size is $5.0mm and with margin of $250.00 on the first month contract. Each contract is negotiated with a point value of $4,167 x the Quoted Price of the contract, which is calculated as 100 minus de average daily Fed Funds Effective Rate for the delivery month. Let’s see an example to make it easier to understand:


Let’s assume that the effective fed funds rate was to average 5.0% for a given month, the settlement quoted price of the fed funds futures contract expiring that month would be 100 – 5.00 = 95.00. The contact value is then expressed in U.S. dollars by multiplying the contract quoted price of 95.00 by the point value of $4,167 x (100 – 5.00) = $395,865.00.


Now, let’s say this contract was being traded before its expiration date when the average effective fed funds rate was at 6.00%. At that time the quote price of the contract would be calculated as 100 – 6.00 = 94.00 and the contract value would be $4,167 x (100 – 6.00%) = $391,698.00. Conversely, if the average effective fed funds rate was at 4.0%, then the quoted price would be 96.00 and the contract value would be calculated as $4,167 x (100 – 4.00) = $400,032.00.



Fed Funds Futures as Rate Change Probabilities

The prices of fed funds futures expiring after FOMC meetings not yet held reflect the market expectations for the outcome of those meetings in terms of federal funds rate targets.


Those market prices can be expressed as probabilities of rate hikes (or cuts) of a given size at those meetings, and CME's Fed Watch Tool provides these. It is important to understand that the probabilities reflect not the objective likelihood of a given outcome but rather current market odds as expressed in fed funds futures trading.


For example, the fed funds futures contract expiring in March 2024 was quoted at 94.735 on January 08, reflecting expectations the effective Fed funds rate would average 5.26% in March 2024.


According to the CME's Fed Watch Tool, this pricing reflected an estimated 67.5% probability of a 0.25% fed funds decrease at the FOMC's March 20 meeting, and a 32.5% probability of no change in fed funds.



In mid-October 2023, market pricing reflected close to 50% probability that fed funds rate would increase by 0.25% in March 2024.



So, if you want to hedge or speculation on the directions of the U.S. fed funds interest rate you can buy or sell futures contract to protect or obtain the equivalent cash flow you would get prior to a change in interest rate.



Sources: Federal Reserve Bank of New York, Board of Governors of the Federal Reserve System, CME Group, Investopedia, Brazen Capital Research.



 


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