Terminal Federal Funds Rate: What It Is and Why It’s Important

What Is the Terminal Federal Funds Rate?

The terminal federal funds rate is the ultimate interest rate level that the Federal Reserve sets as its target for a cycle of rate hikes or cuts. It is the longer-term target rate at which prices are stable and full employment is achieved (sometimes called the neutral rate).

The Fed may incrementally raise or lower rates over time to achieve the terminal rate. The terminal rate itself may be adjusted up or down as the economic environment shifts.

The federal funds (fed funds) rate itself is the current short-term target interest rate set by the Federal Open Market Committee (FOMC). This target is the rate at which commercial banks borrow and lend their excess reserves to each other overnight.

Understanding the Terminal Federal Funds Rate

The Federal Reserve (sometimes shortened to just the Fed) is the central bank of the United States, and it is tasked with a dual mandate to maintain low and stable prices and low unemployment. To fulfill its mandate, the Fed sets and implements the country’s monetary policy.

One of the most common monetary policy tools that the Fed uses is to set the target federal funds rate, or the short-term interest rate target at which commercial banks lend to one another overnight. The Federal Reserve sets the target rate as a benchmark for other interest rates in the economy, and it uses monetary policy tools to influence the current federal funds rate to achieve the terminal rate.

The actual overnight interest rate between banks is set by the market—i.e., the supply and demand for borrowing bank reserves. The federal funds target rate is effectively the cap at which the central bank will step in and lend to banks itself.

As a policy tool, the Fed will lower the fed funds rate target to help stimulate the economy during an economic downturn, as it makes money easier and cheaper to borrow. Alternatively, the Fed can raise the target fed funds rate in response to an overheating economy or to fight high inflation by making money more expensive to borrow.

The terminal federal funds rate is the final interest rate that the Federal Reserve aims to achieve at the end of a monetary policy loosening or tightening cycle. The current federal funds rate, on the other hand, is the interest rate at which depository institutions lend and borrow money in the overnight market. The terminal rate is thus the longer-term target, while the current rate is the short-term rate. Moreover, the terminal federal funds rate is meant to represent the neutral interest rate at which prices are stable and full employment is achieved (i.e., the Fed’s double mandate). 

How the Fed Determines the Terminal Funds Rate

The Federal Reserve’s Federal Open Market Committee (FOMC) is responsible for determining both the current and the terminal federal funds rates. The committee is made up of 12 members: seven members of the Board of Governors, the president of the Federal Reserve Bank of New York, and four of the remaining 11 Reserve Bank presidents, who serve on a rotating basis.

Determining the terminal federal funds rate is not an exact science, and it involves forecasting future economic conditions such as inflation, gross domestic product (GDP) growth, international trade flows, and the unemployment rate. The Fed also considers other indicators, such as the two-year Treasury yield and the broader demand for loans in the economy, to help anticipate the path of interest rates. It then uses monetary policy tools like open market operations (OMOs) to influence the federal funds rate to achieve the terminal rate over time. However, due to the complexity of the economy, it is difficult to identify the terminal rate, and the FOMC runs the risk of making policy mistakes.

The terminal fed funds rate is usually set as a target range, such as 5.00%–5.25% rather than a single figure, and is sometimes represented by economists and analysts as a dot plot, such as the example depicted below. Each dot represents the interest rate projection of an individual committee member for the end of a specific calendar year and over the next few years, and the dots are color-coded to indicate the number of rate increases or decreases that each member expects to occur in the future.

The dot plot can be used to understand the FOMC’s consensus view on the future path of interest rates. The median dot, which is the dot in the middle of the plot, represents the FOMC’s overall projection for the future path of interest rates. The dots above and below the median dot represent the projections of individual FOMC members that are either more or less hawkish than the median projection.

It’s important to understand that the dot plot is a only a forecast and not a commitment by the FOMC, meaning that the interest rate path projected in the dot plot may not actually be followed in practice due to changing economic conditions.

The Bottom Line

The terminal federal funds rate is the final interest rate that the Federal Reserve sets as its target rate for overnight interbank lending. The terminal rate is the long-term target, while the current rate is the short-term rate.

The Federal Open Market Committee (FOMC) sets the target rate as a benchmark for other interest rates in the economy, and it uses monetary policy tools to influence the current federal funds rate to achieve the terminal rate. Determining this rate involves forecasting future economic conditions, and the Fed may change its terminal rate target in response to changing economic conditions.