The federal funds rate is the interest rate at which banks and other financial institutions lend funds (or balances at the Federal Reserve) to other financial institutions—usually on an overnight basis. By law, banks are required to keep a certain percentage of customers' money on reserve, and at a level where banks do not earn interest on the funds. As a result, banks often lend balances to each other as a way to maintain their funds as close to the reserve limit as possible. The reserve limit is determined by the Board of Governors of the Federal Reserve and determines the required minimum amount of capital that a bank must have on hand.

The Federal Reserve uses the federal funds rate to control the supply of available dollars in the economy, which impacts inflation and other interest rates. If the federal funds rate is increased, it costs more to borrow money from your bank – and when borrowing money costs more, available dollars tend to be in shorter supply. This increases short-term interest rates and helps keep the inflation rate at a manageable level. When the federal funds rate is lowered, on the other hand, short-term interest rates go down and consumers tend to borrow more money, which helps stimulate the economy. When you hear news reports about the Federal Reserve changing interest rates, the report is referring to this cycle. However, the Federal Open Market Committee (FOMC) is the body that is actually responsible for setting the target for the federal funds rate, not the actual rate itself (unlike the target rate, the actual rate is determined by the open market). The FOMC is the branch of the Federal Reserve Board that meets confidentially to decide the direction of monetary policy at the Federal Reserve, and to decide whether the money supply should be tightened or loosened based on economic conditions.