Definition
The term federal reserve funds refers to bank reserves held on deposit at the Federal Reserve Bank. In order to clear financial transactions, banks are required to deposit these funds to meet their reserve requirements.
Explanation
Also known as fed funds, federal reserve funds represent overnight borrowing between banks held by the Federal Reserve, and necessary to meet their reserve requirements. A bank's reserve requirement is a function of the customer deposits held by the bank and can range from as low as 3% to as high as 10%. If a depository institution has excess reserves, it is permitted to lend those funds to other institutions that have a reserve deficiency. Typically, these unsecured loans are made for exactly one day and that is why they are sometimes referred to as overnight loans.
The interest rate on these loans is referred to as the fed funds rate and is frequently used as an indicator of interest rate direction. The Federal Reserve Bank sets the interest rate on overnight borrowing, and these rates are one of the levers the Federal Reserve uses to control both the supply of money (via the reserve requirement) and interest rates (via the fed funds rate).
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