Why Does the US Federal Funds Rate Come as a Range? [Seungseop Song's Financial Light]

US Base Interest Rate Was Originally a Number
Triggered by the 2008 Global Financial Crisis
Range Interest Rate Introduced as Target Achievement Became Difficult
"Unfamiliar but More Realistic"

The U.S. Federal Reserve (Fed) is just 5 days away from its final interest rate decision of the year. The prevailing expectation is that the benchmark interest rate will be held steady at 5.25?5.5%. Since the U.S. benchmark interest rate significantly influences countries worldwide, including South Korea, it draws considerable attention. However, there is something peculiar. South Korea’s benchmark interest rate is set at a fixed number, 3.5%. But the U.S. expresses it as a range. Why does this difference exist?

[Image source=Reuters Yonhap News]

To understand this, we need to look more closely at the U.S. benchmark interest rate system. U.S. commercial banks are required to deposit a certain percentage of their funds with the Fed as reserves, to prepare for large withdrawals. This is called the reserve requirement. Banks with excess funds can lend these reserves to banks that lack them for a very short period. Of course, interest is charged on these loans. The interest rate applied to these ultra-short-term transactions between banks is called the federal funds rate. The rate announced by the Fed is this federal funds rate, which we commonly refer to as the benchmark interest rate for convenience.

Another point: the Fed’s benchmark interest rate is a target rate. Announcing a benchmark rate of 5% does not mean that all transactions must uniformly apply a 5% interest rate. Interest rates are autonomously determined by supply and demand. Rather, it means that the central bank aims to keep the interest rate as close to 5% as possible. If the rate deviates from 5%, the Fed intervenes in the market by buying or selling assets to adjust liquidity and bring the rate back to the target of 5%.

The U.S. originally presented its benchmark interest rate as a single number, like South Korea. The first time it was presented as a range was on December 16, 2008. At that time, the Fed adjusted the benchmark rate from 1% to “0?0.25%.” This drastic cut was made to overcome the global financial crisis sweeping the world, and the rate was announced as a range rather than a single number. While range rates are familiar now, this decision by the U.S. central bank was quite a sensation at the time.

The background involves Fannie Mae and Freddie Mac. Fannie Mae and Freddie Mac were U.S. government-sponsored enterprises that guaranteed mortgage loans. They helped people buy homes by making it easier to borrow from banks but collapsed during the global financial crisis. The U.S. government rescued the two companies with a record $200 billion bailout, instructing them not to invest profits in other assets but to supply funds to the short-term financial market.

However, side effects emerged. Massive funds began flooding the financial market. As money in the market surged, short-term interest rates plummeted sharply. Actual market rates even fell to around 0.1%. It became difficult to meet the target rate despite efforts. So, the Fed came up with an idea: to present the rate as a range rather than a fixed number.

In other words, presenting the rate as a range is a measure to more easily achieve the target. If the benchmark rate is a specific number, even a slight movement in the rate means the target is not met in principle. But if the benchmark rate is a range, as long as the rate falls within that range, it is considered that the “benchmark rate target has been achieved.” This better reflects market conditions. According to the Wall Street Journal (WSJ) in 2008, a Fed official described the range rate as “unfamiliar but more realistic.”

This is also related to the interest the Fed pays. U.S. banks are required to deposit a certain level of reserves with the Fed. However, in October 2008, the Emergency Economic Stabilization Act was enacted due to the global financial crisis. The law stipulated that financial institutions depositing reserves above the mandatory level would receive 0.25% interest on those deposits. Therefore, even a benchmark rate of 0.25% effectively functioned as a zero interest rate.

Editor's NoteEconomics and finance are difficult subjects due to complex terminology and background stories. Financial Light delivers easy-to-understand economic and financial stories every week. Even without any prior knowledge, these stories flow smoothly to ignite your interest in economics and finance.