What It Is:
Federal funds are monies held by banks at the Federal Reserve to meet reserve requirements. Funds in excess of reserve requirements can be loaned to other banks in order for those banks to meet reserve requirements.
How It Works/Example:
Federal funds loans are unsecured and are for very short periods, typically overnight. They are usually made through brokers who specialize in such transactions, or they are arranged directly between the banks themselves. The interest rate on a federal funds loan is called the federal funds fate.
Why It Matters:
Changes in the federal funds fate compel banks to either borrow federal funds to meet reserves requirements or build them up internally. These decisions affect how much money is available for lending to bank customers. The resulting increase or decrease in the supply of money available for lending usually affects overall interest rates, and factors into economic stability -- the ultimate objective of the Fed.
Although the Federal Reserve cannot directly control Federal Funds activity, it can manipulate it. The Fed does this primarily by offering competing loans to banks. Manipulation of the Federal Funds Rate is one of three primary methods the Federal Reserve uses to control the money supply. (The other two involve changing reserve requirements and buying or selling U.S. Treasuries on the open market.)