Federal funds rate

The rate applies to unsecured overnight lending of balances held at the Federal Reserve, between banks that have more of them than they need and banks that have fewer. The committee that sets policy does not fix the rate directly. It announces a target range and the New York Federal Reserve keeps the market rate inside that range using administered rates, principally the interest paid on reserve balances and the rate offered on overnight reverse repurchase agreements. The published figure, the effective federal funds rate, is a volume weighted median of the previous day's actual transactions, so it is an observation of the market rather than a decree.

Because it is the shortest dollar rate, it anchors the front end of the dollar curve, and everything priced off that curve moves with expectations for it: the differential between dollar rates and other currencies' rates, which drives forward pricing and carry, and the discount rate applied to future company earnings, which is one channel through which rate expectations reach equity indices. Currencies pegged to the dollar inherit the constraint directly, which is why Gulf central banks with dollar pegs commonly move their own policy rates in step with the Federal Reserve.

The most common misreading is to treat the announced level as the tradable event. Markets price the expected path of the rate continuously, so by the time a decision arrives most of it is already in the price, and the reaction usually comes from the change in the expected path signalled by the statement, the projections and the press conference rather than from the decision itself.