In the United States, the federal funds rate is the interest rate at which private depository institutions (mostly banks) lend balances (federal funds) at the Federal Reserve to other depository institutions, usually overnight.[1] It is the interest rate banks charge each other for loans.[2] Changing the target rate is one way the Chairman of the Federal Reserve can influence the supply of money in the U.S. economy.[3]. The federal funds target rate is determined by a meeting of the members of the Federal Open Market Committee which normally occurs eight times a year about seven weeks apart. The committee may also hold additional meetings and implement target rate changes outside of its normal schedule.
Mechanism
U.S. banks and thrift institutions are obligated by law to maintain certain levels of reserves, either as reserves with the Fed or as vault cash. The level of these reserves is determined by the outstanding assets and liabilities of each depository institution, as well as by the Fed itself, but is typically 10%[4] of the total value of the bank's demand accounts (depending on bank size).
For example, assume a particular U.S. depository institution, in the normal course of business, issues a loan. This dispenses money and decreases the ratio of bank reserves to money loaned. If its reserve ratio drops below the legally required minimum, it must add to its reserves to remain compliant with Federal Reserve regulations. The bank can borrow the requisite funds from another bank that has a surplus in its account with the Fed. The interest rate that the borrowing bank pays to the lending bank to borrow the funds is negotiated between the two banks, and the weighted average of this rate across all such transactions is the federal funds effective rate.
The nominal rate is a target set by the governors of the Federal Reserve, which they enforce primarily by open market operations. That nominal rate is almost always what is meant by the media referring to the Federal Reserve "changing interest rates". The actual Fed funds rate generally lies within a range of that target rate, as the Federal Reserve cannot set an exact value through open market operations.
Another way banks can borrow funds to keep up their required reserves is by taking a loan from the Federal Reserve itself at the discount window. These loans are subject to audit by the Fed, and the discount rate is usually higher than the federal funds rate. Confusion between these two kinds of loans often leads to confusion between the federal funds rate and the discount rate. Another difference is that while the Fed cannot set an exact federal funds rate, it can set a specific discount rate.
The federal funds rate target is decided by the governors at Federal Open Market Committee (FOMC) meetings. The FOMC members will either increase, decrease, or leave the rate unchanged depending on the meeting's agenda and the economic conditions of the U.S. It is possible to infer the market expectations of the FOMC decisions at future meetings from the Chicago Board of Trade (CBOT) Fed Funds futures contracts, and these probabilities are widely reported in the financial media.
Applications
Interbank borrowing is essentially a way for banks to quickly raise capital. For example, a bank may want to finance a major industrial effort but not have the time to wait for deposits or interest (on loan payments) to come in. In such cases the bank will quickly raise this amount from other banks at an interest rate equal to or higher than the Federal funds rate.
Raising the federal funds rate will dissuade banks from taking out such inter-bank loans, which in turn will make cash that much harder to procure. Conversely, dropping the interest rates will encourage banks to borrow money and therefore invest more freely.[5] Thus this interest rate acts as a regulatory tool to control how freely the US economy, and by consequence—as there exists a certain interdependence—world economy, operates.
By setting a higher discount rate the Federal Bank discourages banks from requisitioning funds from the Federal Bank, yet positions itself as a source of last resort.
Comparison with LIBOR
Though the London Interbank Offered Rate (LIBOR) and the federal funds rate are concerned with the same action, i.e. interbank loans, they are distinct from one another, as following:
- The target federal funds rate is a target interest rate that is set by the FOMC for implementing U.S. monetary policies.
- The (effective) federal funds rate is achieved through open market operations at the Domestic Trading Desk at the Federal Reserve Bank of New York which deals primarily in domestic securities (U.S. Treasury and federal agencies' securities).[6]
- LIBOR is calculated from prevailing interest rates between highly credit-worthy institutions.
- LIBOR may or may not be used to derive business terms. It is not fixed beforehand and is not meant to have macroeconomic ramifications.[7]
Predictions by the market
Considering the wide impact a change in the federal funds rate can have on the value of the dollar and the amount of lending going to new economic activity, the Federal Reserve is closely watched by the market. The prices of Option contracts on fed funds futures (traded on the Chicago Board of Trade) can be used to infer the market's expectations of future Fed policy changes. One set of such implied probabilities is published by the Cleveland Fed.
Historical rates
As of December 16, 2008, the most recent change the FOMC has made to the funds target rate is a 75-100 basis point cut from 1.0% to a range of zero to 0.25%. (According to Jack A. Ablin, chief investment officer at Harris Private Bank, one reason for this unprecedented move of having a range, rather than a specific rate, was because a rate of 0% could have had problematic implications for money market funds, whose fees could then outpace yields[8].) This followed the .5% cut on October 29, 2008.[9] This followed the unusually large 75 basis point cut made during a special January 22, 2008 meeting in response to the stock market turmoil that January,[9] as well as a 50 basis point cut on January 30, 2008, a 75 basis point cut on March 18, 2008, and a 50 basis point cut on October 8, 2008.
Historical chart of the effective Federal Funds Rate
Explanation of federal funds rate decisions
When The Fed wishes to reduce interest rates they will increase the supply of money by buying government securities. When additional supply is added and everything else remains constant, price normally falls. In this case the price that is referred to is the Federal Funds Rate. Conversely, when The Fed wishes to increase the Fed Funds Rate, they will instruct the Open Market Committee to sell government securities thereby taking the money they earn on the proceeds of those sales out of circulation and reducing the money supply. When supply is taken away and everything else remains constant, price (or in this case interest rates) will normally rise.[10]
The Federal Reserve has responded to a potential slow-down by lowering the target federal funds rate during recessions and other periods of lower growth. In fact, the Federal Reserve lowering has recently predated recessions[9] because as interest rates are increased to slow economic growth, interest payments on all debts rise. To the extent these increases in debt service leads to defaults and forced selling, this can be extremely destructive to asset values and the financial system, as seen in 2008. The charts show the impact on S&P 500 and short- and long-term interest rates. Bill Gross of Pimco has suggested that in the past 15 years, every time the fed funds rate was higher than the nominal GDP growth rate, assets such as stocks and/or housing always fell. He even suggested that the best way to price the fed funds rate would be 100 basis points below the nominal GDP growth rate.[11]
See also
References
External links
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