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Federal funds rate

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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] Changing the target rate is one form of open market operations that the Chairman of the Federal Reserve uses to regulate the supply of money in the U.S. economy.[2]

Mechanism

U.S. banks and thrift institutions are obligated by law to maintain certain levels of reserves, either as non-interest-bearing 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% of the total value of the bank's demand accounts.

For example, assume a particular U.S. depository institution, in the normal course of business, issues a loan. This dispenses money and reduces the bank's reserves. If its reserve level falls 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 effective federal funds rate.

The nominal rate is a target set by the governors of the Federal Reserve, which they enforce primarily by open market operations. When the media refer to the Federal Reserve "changing interest rates," this nominal rate is almost always meant. The actual Fed funds rate generally lies within a range of the 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 at Federal Open Market Committee (FOMC) meetings. Depending on their agenda and the economic conditions of the U.S., the FOMC members will either increase, decrease, or leave the rate unchanged. 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.[3] Thus this interest rate acts as a regulatory tool to control how freely the US economy, and by consequence 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 LIBOR and the federal funds rate are concerned with the same action, i.e. interbank loans, they are distinct in that:

  • The Federal funds rate is a target interest rate that is fixed by the FOMC for implementing USA's monetary policies.
  • The Fed 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).[4]
  • 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.[5]

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

See also: History of Federal Open Market Committee actions

As of February 11, 2008, the most recent change the FOMC has made to the funds rate was a 50 basis point cut from 3.5% to 3.0% on January 30, 2008.[6] 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.[6]

Historical chart of the effective Federal Funds Rate

Impact of Federal funds rate cuts

The Federal Reserve has responded to potential slow-down by lowering the target Federal funds rate during the recessions and other periods of lower growth. In fact the federal reserve lowering has recently predated recessions.[6]. The charts show the inpact on S&P500 and short and long interest rates.

See also

References

  1. ^ "Federal Funds - Fedpoints" (HTML). Federal Reserve Bank of New York. August 2007. Retrieved 2007-11-24.
  2. ^ "Monetary Policy, Open Market Operations" (HTML). Federal Reserve Bank. 2008-01-30. Retrieved 2008-01-30. {{cite web}}: Check date values in: |date= (help)
  3. ^ Fed funds rate; Bankrate.com
  4. ^ Open Market Operations in the 1990s
  5. ^ www.bba.org.uk
  6. ^ a b c Historical Changes of the Target Federal Funds and Discount Rates from the New York Federal Reserve Branch.
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