The Fed Funds Rate is Expected to Rise Within Its Range as Costs Rise

The effective federal funds rate which has sat near the bottom of the Federal Reserve’s target range for the past two years may soon climb, signaling that excess liquidity in the banking system is drying up faster than expected.

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One driver of this shift is the Treasury Department’s stepped-up issuance of short-term bills since July, which has pulled cash out of the system and put upward pressure on ultra-short-term rates.

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Although the fed funds rate is designed to move within a 25-basis-point range, it has remained unusually stable in recent years, only shifting when the Fed itself adjusted policy. That consistency has stood in contrast to other short-term benchmarks, sparking debate over whether fed funds is still the best gauge for monetary conditions. If the rate edges higher outside of a scheduled policy move, it could signal growing sensitivity to tightening liquidity.

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“We’re approaching that point faster than anticipated,” wrote Wrightson ICAP senior economist Lou Crandall. He suggested market activity hints the effective rate “might already be flirting with an uptick from 4.08% to 4.09%,” though he noted a sustained move could still take weeks.

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The underlying issue is shrinking bank reserves. Commercial banks have been reducing balances held at the Fed, and foreign banks are cutting even more aggressively than their U.S. peers.

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Wall Street strategists are watching these reserve levels closely. Usage of one of the Fed’s overnight lending tools often viewed as a barometer of surplus liquidity has dropped to a four-year low. Reserves remain above $3 trillion, but if they fall closer to $2.7 trillion, the level Fed Governor Christopher Waller recently described as the “lowest comfortable threshold,” the central bank may need to intervene to prevent disruptions.

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Historically, the fed funds market served as the main signal of tightening financing conditions. But after the flood of stimulus during the financial crisis and pandemic, banks largely bypassed that market, choosing instead to deposit excess dollars directly with the Fed.

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Now, with liquidity thinning, the volume of fed funds transactions has been slipping, particularly among foreign institutions. “Aggregate reserve balances at foreign banks have fallen more sharply and earlier than we expected this month,” Crandall noted. Fed data show foreign banks cut dollar holdings for three straight weeks through September 10, the longest such streak this year.

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Analysts are split on the timing of any meaningful rise in the fed funds rate. Crandall sees an increase in the near term, while Citigroup’s Jason Williams and Alejandra Vazquez Plata argue the reserve distribution hasn’t shifted enough yet. Still, they acknowledge the rate could drift one to two basis points higher by year-end.

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Here are the key areas investors are tracking to assess when fed funds might break higher:

‍Foreign Bank Cash
Foreign banks have reduced cash assets by about $255 billion over three weeks ending September 10, bringing balances to their lowest level since late 2024, according to Fed data. When flush with liquidity, these banks engage in “Fed arbitrage” borrowing in the fed funds market and depositing the money at the Fed to earn the Interest on Reserve Balances (IORB), now at 4.15%. As their excess reserves decline, however, borrowing costs in fed funds and Eurodollar markets tend to rise, signaling tighter conditions.

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Fed Funds Volumes
With foreign banks stepping back, the volume of fed funds trades has thinned. According to Wrightson ICAP, volumes have stayed below $100 billion for about a week, down from an average of $113 billion since late April. Citigroup strategists expect volumes to drop further before smaller U.S. banks step in. For context, domestic banks accounted for only 7% of fed funds volume in Q1 2025, compared to 26% back in 2018.

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The 75th Percentile
Before last week’s policy rate cut, the 75th percentile of fed funds transactions a proxy for bank funding costs had already been creeping higher. Historically, this distribution shift precedes a broader move in the median rate, though it typically lags behind other benchmarks like the Secured Overnight Financing Rate (SOFR). Bank of America strategists Mark Cabana and Katie Craig noted that fed funds would likely require one to two weeks of sustained pressure in discount note markets relative to other money-market rates before making a decisive move higher.

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