Federal Funds Rate

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  Federal Reserve System (central banking system of the United States)

  • (Author)
  • 2014(Publication Date)
  • White Word Publications

    (Publisher)

  The Federal Funds Rate is a short-term interest rate the FOMC focuses on directly. This rate ultimately affects the longer-term interest rates throughout the economy. A summary of the basis and implementation of monetary policy is stated by the Federal Reserve: The Federal Reserve implements U.S. monetary policy by affecting conditions in the market for balances that depository institutions hold at the Federal Reserve Banks...By conducting open market operations, imposing reserve requirements, permitting depository institutions to hold contractual clearing balances, and extending credit through its discount window facility, the Federal Reserve exercises considerable control over the demand for and supply of Federal Reserve balances and the Federal Funds Rate. Through its control of the Federal Funds Rate, the Federal Reserve is able to foster financial and monetary conditions consistent with its monetary policy objectives. This influences the economy through its effect on the quantity of reserves that banks use to make loans. Policy actions that add reserves to the banking system encourage lending at lower interest rates thus stimulating growth in money, credit, and the economy. Policy actions that absorb reserves work in the opposite direction. The Fed's task is to supply enough reserves to support an adequate amount of money and credit, avoiding the excesses that result in inflation and the shortages that stifle economic growth. Tools There are three main tools of monetary policy that the Federal Reserve uses to influence the amount of reserves in private banks: Tool Description open market operations purchases and sales of U.S. Treasury and federal agency securities— the Federal Reserve's principal tool for implementing monetary policy. The Federal Reserve's objective for open market operat ions has varied over the years.

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  Helping the Federal Reserve Work Smarter

  • Leonard Jay Santow(Author)
  • 2016(Publication Date)
  • Routledge

    (Publisher)

  These recommendations neither interfere with the free market mechanism nor attempt to reregulate. Rather, they endeavor to make an existing system and existing policy instruments more effective.

  The Federal Funds Rate

  When one is looking at policy results from 1964 to 1993, one must examine several variables. The Federal Funds Rate, the discount rate, discount window borrowings, required reserves, and M1 are especially important. These variables, when viewed as a package, reflect monetary policy during the three decades under review.

  Commercial banks buy and sell reserves on a daily basis. These transactions are referred to as the federal funds market, and the rate at which these funds trade is called the Federal Funds Rate. Usually small banks and banks with large core deposits have excess reserves and will sell some of these funds to more aggressive banks that are in need of funds. If the less aggressive banks do not sell a significant amount of their excess reserves, the more aggressive banks will be short of funds, and the result will be an adverse distribution of funds in the banking system and a relatively high Federal Funds Rate. The Fed usually adds reserves to the banking system to offset the adverse distribution.

  The funds rate can be strongly influenced by the Federal Reserve. The Fed can add reserves through repurchase agreements (RPs) using Treasury or agency securities as collateral, or through outright purchases of Treasury and agency securities. Repurchase agreements are a financing mechanism whereby a purchaser can buy debt securities and at the same time agree to sell them back at a later date, at a given price. The Fed can drain reserves by doing matched sales (reverse RPs), and by outright sales of Treasury and agency securities. It can also run off holdings of maturing issues.

  The central bank is incapable of attaining a desired average Federal Funds Rate on a daily basis. In a given week, however, the Fed can usually come close—to within one-eighth of a percentage point. The Fed usually does better when targeting funds over a two-week bank statement period because unusual days for funds have the opportunity to average out. But when special situations occur, such as the end of a quarter, unexpected swings in Treasury balances at the Fed, or major surprises in factors affecting reserves, the average funds rate for a day, or several days, can be one percentage point or more away from the Fed's target.

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  Introduction to Finance

  Markets, Investments, and Financial Management

  • Ronald W. Melicher, Edgar A. Norton(Authors)
  • 2020(Publication Date)
  • Wiley

    (Publisher)

  One interest rate that the Fed’s FOMC could focus on is the Federal Funds Rate, which is the rate on overnight loans from banks with excess reserves to banks that have deficit reserves. Open-market purchases of securities add to bank reserves and increase the money supply. Sales of securities lower reserves and the money supply. However, when the target is the money supply, interest rates may fluctuate widely, because the demand for money may change relative to a specific money supply target. Furthermore, a focus on the money supply might not produce the desired impact on gross domestic product because of changes in the velocity of money, as we saw in Chapter 2. In recent years, the Fed, through its FOMC, has chosen to focus on setting target interest rate levels for the Federal Funds Rate as the primary means of carrying out monetary policy. Evidence indi- cates that observed Federal Funds Rates track closely with the Fed’s target Federal Funds Rates over time. Banks with excess reserves lend to banks that need to borrow funds to meet reserve requirements. Interest rates, such as the Federal Funds Rate, reflect the intersection of the demand for reserves and the supply of reserves. Open-market purchases of securities cause the Federal Funds Rate to fall, whereas sales of securities cause the rate to rise. Of course, while the FOMC can set targets for Federal Funds Rates, actual Federal Funds Rates are determined in the market by banks with excess reserves and banks that need to borrow reserves to meet their minimum reserve requirement. The Fed uses its open-market operations to provide liquidity to the banking system in times of emergency and distress. For example, the stock market crash on October 19, 1987, caused concern about a possible economic collapse. The Fed, through FOMC open-market purchases, moved quickly to increase the money supply.

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  Financial Markets & Institutions

  • Jeff Madura(Author)
  • 2020(Publication Date)
  • Cengage Learning EMEA

    (Publisher)

  The chair of the Fed may offer a recommendation and usually has some influence over the other mem- bers. The participants are commonly given three options for monetary policy, which are intended to cover a range of the most reasonable policies and should include at least one policy that is satisfactory to each member. FOMC Decisions After the discussion, the voting members of the FOMC vote on whether the Federal Funds Rate target should be changed. Most decisions are unanimous, but it is not unusual to have one or two dissenting votes. The Federal Funds Rate is the rate charged by banks on short-term loans to each other. Even though this rate is determined by the banks that participate in the federal funds market, it is subject to the supply of and demand for funds in the banking system. Thus, the Fed influences the Federal Funds Rate by revising the supply of funds in the banking system. The target may be specified as a specific point estimate, such as 2.5 percent, or as a range, such as from 2.5 to 2.75 percent. Because all short-term interest rates are affected by the supply of and demand for funds in the banking system, the Fed’s actions will affect not just the Federal Funds Rate, but other interest rates as well. If the FOMC is concerned that the economy is weak and if it is not concerned about inflation, it would recommend that the Fed implement a monetary policy to reduce the Federal Funds Rate. Exhibit 4.3 shows how the Federal Funds Rate was reduced near the end of 2007 when signs of the credit crisis and recession in 2008 became noticeable. In December 2008, the Fed set the target for the Federal Funds Rate at a range between 0 and 0.25 percent. The goal was to stimulate the economy by reducing interest rates to their minimum level in an effort to encourage more borrowing and spending by households and businesses. The Fed main- tained the Federal Funds Rate within this range over the 2009–2015 period; other interest rates were also low during this period.

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  Market-Based Interest Rate Reform in China

  • China Finance 40 Forum Research Group(Author)
  • 2018(Publication Date)
  • Routledge

    (Publisher)

  It is necessary to point out that the approaches focusing on open market operations and the interest rate corridor are complementary and interconnected. Refinancing (rediscount) is common among almost all central banks. Only some central banks do not pay interest on financial institutions’ deposits (one-side interest rate corridor). After the 2008 global financial crisis, both the US and Japan started to pay interest on (surplus) reserve, leading to the emergence of interest rate corridors and deposit and lending facilities. Adjustment through the interest rate corridor has become a trend (Hu, 2014). At the end of 2008, the Federal Reserve started to pay interest on depository institutions’ required and surplus reserves. Currently, the Federal Reserve pays an interest of 1.25 percent (the upper limit of Federal Funds Rate target) on surplus reserve, which actually imposes a lower limit on money market rates. Regarded as the lending facility rate, the federal discount rate is 1.75 percent at the moment. The target range of the Federal Funds Rate is 1–1.25 percent and it seems unlikely for the rate to be zero. Therefore, the Federal Reserve’s interest rate corridor covers a range of 50 basis points. However, institutions outside the Federal Reserve System cannot get interest on their reserves and are thus willing to lend money at a rate lower than the lower limit of deposit rates. Therefore, the effective Federal Funds Rate remains 10 to 15 basis points below the target (Bech and Klee, 2011). As discount business decreases, the Federal Reserve manages liquidity mainly through open market operations. Deposit and lending facilities are less frequently used and less effective in interest rate guidance. The Federal Reserve achieves its monetary policy objectives mainly through open market operations. Japan’s situation is similar to that in the US. In Japan, however, the target rate is at a lower level (near zero).

  The ECB will remunerate minimum reserve holdings at a level corresponding to the rate of its main refinancing operations (MRO). In July 2012, the MRO rate dropped to 0.75 percent and the rate under the deposit facility dropped to zero. Faced with a weak economy and potential deflation, on June 11, 2016, the ECB lowered the MRO rate by 10 basis points to 0.15 percent, overnight deposit rate (0 percent originally) by 10 basis points to −0.1 percent, and overnight lending rate by 35 basis points to 0.4 percent. These measures were applied to eurozone countries, thus initiating an age of negative rates. On September 10, 2014, the ECB further cut the MRO rate to 0.05 percent (a near zero level), deposit facility rate to −0.2 percent, and marginal lending facility rate to 0.3 percent. Therefore, as policy rates are near zero bound, ECB takes a similar approach as the US before the financial crisis. The market rates face an upper limit (the rate under marginal lending facility) but no effective lower limit. Market rates fluctuate around the target level and move closer to zero bound.

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  Strategies for Monetary Policy

  • John H. Cochrane, John B. Taylor, John H. Cochrane, John B. Taylor(Authors)
  • 2020(Publication Date)
  • Hoover Institution Press

    (Publisher)

  Under our fiat money system, this institutional arrangement is embodied by the Federal Reserve. It is up to the Fed to conduct monetary policy in a way that pins down the aggregate nominal price level. The Fed achieves this goal by exercising its monopoly control over the supply of base money: currency plus bank reserves.

  Today, as before the crisis, the Fed implements monetary policy by targeting the Federal Funds Rate. The Federal Funds Rate, however, is a market rate of interest, charged by one bank to another on a very short-term loan of reserves. The Fed does not set the funds rate directly. Instead, the Fed’s operating procedures must link the Federal Funds Rate, which the Fed can only influence, to the monetary base, which the Fed can precisely control.

  Before the financial crisis of 2007– 2008, the link between the funds rate and the supply of base money was more immediate and therefore more obvious. Whenever the Fed wanted to lower its target for the funds rate, it conducted an open market purchase, buying US Treasury securities to inject new reserves into the banking system. The increased supply of bank reserves put downward pressure on the equilibrium funds rate, moving it lower in line with the new target. Conversely, whenever the Fed wanted to raise its target for the funds rate, it conducted an open market sale of US Treasury securities to drain reserves from the banking system and put upward pressure on the funds rate.

  Since December 2015, however, the Fed has gradually lifted its Federal Funds Rate target off its zero lower bound using a floor system. Under this floor system, the Fed uses its newly granted ability to pay interest on reserves to manipulate the Federal Funds Rate, without having to conduct open market operations right away. By raising the interest rates paid to banks on reserves and nonbank financial intermediaries on reserve repurchase agreements, the Fed has successfully moved the Federal Funds Rate up in lockstep. And, presumably, when the next easing cycle begins, the Fed will lower the interest rates on reserves and reverse repurchase agreements to bring the Federal Funds Rate back down.

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  The Great American Housing Bubble

  The Road to Collapse

  • Robert M. Hardaway(Author)
  • 2011(Publication Date)
  • Praeger

    (Publisher)

  The Federal Reserve has four primary tools in particular: the discount rate; open market operations; regulation and supervision; and setting reserve requirements. 26 Open market operations and regulation will be the primary focus of this chapter, but a brief understanding of each is necessary. The discount rate is essentially how much it costs to borrow money from the Federal Reserve and is largely symbolic. Second, the open mar- ket operations consist of buying and selling government securities and are under the control of the Federal Open Market Committee (FOMC). 27 The FOMC, established through the Bank Act of 1933, consists of the seven members of the Federal Reserve Board, the president of the Federal Reserve Bank of New York, and four other members that rotate between heads of the other 11 regional Federal Reserve banks. The committee meets every five to eight weeks. The tightening and loosening of money through the open market is reflected in the Federal Funds Rate. The Federal Funds Rate is the overnight rate charged when banks borrow from each other. The Federal Funds Rate and the discount rate usually move together. The Federal Reserve 119 Third, the Federal Reserve has regulation and supervision over the banks within its control, and will be discussed in more detail later. The last and least used—but still powerful—of the tools is the ability of the Board of Governors to restrict available cash by changing the minimum reserve requirement that banks must keep on hand. 28 A large caveat exists to the Federal Reserve’s use of tools to control the economic outlook of the United States as well as the global economy. The implementation of monetary policy is by no means a sci- ence, but rather one of art. The battle of the Federal Reserve since its cre- ation has been to foster an atmosphere conducive to allowing it to freely work within its framework to try to outguess the economy. WHEN AND WHY In the world of homeownership, the mortgage rate plays a key role.

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  Experiments in Credit Control the Federal Reserve System

  • Caroline Whiitney(Author)
  • 2019(Publication Date)
  • Columbia University Press

    (Publisher)

  The Federal Reserve banks have claimed that they are effective and that a decline in interest rates has always followed purchases of government bonds. Such a consequence logically follows a release of funds at the chief financial center or the country—New York City. But if Federal funds are in great demand to obtain Federal Reserve notes for internal circulation or to obtain gold from the Reserve banks for export, the Reserve banks may engage in open market operations without any marked influence on interest rates. The interest rates first affected will be the rates on the securities purchased—United States securities and bankers' acceptances—and the rate on Federal funds. It is only when the banks from which securities have been purchased replace their purchases with other paper or when other banks purchase the excess Reserve balances from them in the market for Federal funds that other interest rates feel the effect of a purchase of government securities or of accept-ances by the Reserve banks. If member banks do not wish to expand their loan and in-vestment portfolios, but fear future withdrawals of gold or of currency, they will hold these reserves as excess reserves. Smaller member banks will redeposit them in larger banks and bankers' balances will rise. These bankers' balances, being a sort of emergency reserve of banks all over the country, should not be loaned, but be held pending the emergency. 6 Hearings Pursuant to S. Res. 71, appendix, part 6, pp. 795-796. INTEREST RATES 15 7 Chart 14, showing a comparison between open market holdings of securities and of bankers' acceptances, the latter corrected for seasonal variations, held by Reserve banks and open market interest rates on short term government securi-ties and on bankers' acceptances, indicates the exceptions to the rule that open market operations influence interest rates occurred at times when gold or currency was in demand.

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  Explaining and Forecasting the US Federal Funds Rate

  A Monetary Policy Model for the US

  • M. Clements(Author)
  • 2003(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  INTRODUCTION The Fed describes monetary policy as ‘actions undertaken ... to influ- ence the availability and cost of money and credit to help promote national economic goals’. The Federal Reserve Act specifies that in conducting monetary policy, the Federal Open Market Committee (FOMC) should seek ‘to promote effectively the goals of maximum employment, stable prices, and moderate long term interest rates’. The Fed controls the three main tools of monetary policy: open market operations (the FFR), the discount rate, and reserve require- ments. This book examines only the FFR, which is influenced by open market operations, the buying and selling of securities, which is the Fed’s primary instrument for controlling monetary policy. The FOMC is responsible for open market operations and setting the FFR. The committee comprises 12 voting members and meets at eight scheduled meetings a year. The FFR is the interest rate at which depository institutions (banks) lend balances at the Fed to each other overnight. Changes in the FFR in turn affect other interest rates, both long and short term, such as government and corporate bonds, mort- gage and credit rates. The exchange rate of the dollar is also sensi- tive to changes in the FFR. Using this rate, the Fed can affect the price of money and credit. In this way it influences employment, output and inflation. Strictly speaking, the Fed’s mandate of ‘price stability’ is a misnomer. Price stability means, by definition, zero inflation. Also, CHAPTER 2 Monetary Policy at the US Federal Reserve 27 the mandate does not specify which inflation measure should be targeted. In reality, the Fed looks to achieve inflation stability using an inflation measure that it considers to best represent price move- ments across the economy. In February 2000, the Fed ostensibly signalled a preference for the Commerce Department’s Personal Consumption Expenditure (PCE) price index as its chosen inflation measure.

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  Money, Banking, and Financial Markets

  A Modern Introduction to Macroeconomics

  • Dale K. Cline, Sandeep Mazumder(Authors)
  • 2022(Publication Date)
  • Routledge

    (Publisher)

  Whenever the Fed begins to taper QE actions, talk of unwinding its bond purchases invariably occurs. Some believe that it will lead to economic instability or inflation. Since we understand that, because loan creation and the money supply is not affected by the size of the banking system’s reserve pool, we also understand that tapering QE will not lead to inflation. However, the markets may react to perceived changes in Fed policy and that may lead to instability. Therefore, the Fed must use caution and employ various tools to control the Fed funds rate as it alters its program. The interest paid on excess reserves allows the Fed to control the rate more accurately and quickly. Effectively serving as the lower boundary, the interest rate paid on reserves serves makes it easier to fine tune the rate, providing the ability to make adjustments without changing the levels of reserves.

  Velocity and other economic indicators

  Economists define the money supply in terms of layers which build successively upon each other, moving from the most liquid to the least. The most-narrow layer, called the monetary base, includes actual cash in circulation and reserve accounts at the central bank, while the broad category of M3 encompasses larger, longer-term deposits, including institutional funds. M2 includes all notes and coins in circulation, cash equivalents and cash accounts except for time deposits of $100,000 or more, so it is fairly representative of the currency available to us to carry out our daily activities. But why does keeping a measure of the money supply matter? Well, many economists believe that the size of our money supply can be used as one guide to understanding and predicting both short-term economic variables as well as longer-term movements such as inflation, helping Fed officials to determine the appropriate course of action in terms of monetary policy.

  To view the money supply as an economic indicator, one must recognize that it should be expressed in terms of its relationship to other economic measures. For example, based on U.S. quarterly data from 1981 to 2019, M2 multiplied by approximately 1.8 equals the Gross Domestic Product (GDP), with GDP being defined as the total output of goods and services for, typically, a 1-year period. Figure 5.4

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  The Financial System and the Economy

  Principles of Money and Banking

  • Maureen Burton, Bruce Brown(Authors)
  • 2014(Publication Date)
  • Routledge

    (Publisher)

  Owing to uncertainties about the behavior of debt and money, these ranges for many years have not provided useful benchmarks for the conduct of monetary policy. d As a consequence of all these changes, today the Fed uses the fed funds rate as the operating target and explicitly announces its short-term objective for that target after each FOMC meeting. Endnotes a. In addition to M1 and M2, the Fed used to track another measure of money, M3. M3 is an even broader measure of money than M2 and consists of everything in M2 plus large time deposits, term repurchase agreements and term Eurodollars, and institutional money market mutual funds. The correlation between changes in M3 and economic activity also broke down in the 1990s. M3, a measure of money tracked by the Fed was discontinued by the Fed in March 2006. b. Recall from Chapter 3 that, prior to January 2003, the discount rate was set by the Board of Governors and changed rather infrequently in response to requests from the Federal Reserve Banks. Changes in the discount rate usually lagged behind changes in other interest rates. At that time, the discount rate was often below other rates at which depository institutions could borrow reserves in the fed funds market. In January 2003, the primary credit rate (the discount rate at which the most creditworthy institutions can borrow) was set 1 percent above the targeted fed funds rate. In August 2007, the Fed approved a narrowing of the spread between the targeted fed funds rate and the primary credit rate to 0.5 percent. The purpose of the reduction in the spread was to mitigate the liquidity crisis caused by the subprime mortgage debacle, which spread to broader markets. The change was temporary but still in effect in late 2008

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  Handbook of Monetary Economics

  • Benjamin M. Friedman, Michael Woodford(Authors)
  • 2010(Publication Date)
  • North Holland

    (Publisher)

  The BOJ introduced its “complementary lending facility” to lend overnight reserves to banks, in place of its traditional discount window, in 2001, with the rate normally set at 25 basis points above the call rate target. Only in 2008, when the target call rate was back to near zero in the context of the 2007–2009 financial crisis, did the bank introduce its “complementary deposit facility,” under which all holdings of excess reserves are automatically deemed to be deposited overnight for purposes of receiving the stated interest rate. 51 The Federal Reserve augmented its discount window with a “primary credit facility” in 2003, with the rate charged set at 1% above the target Federal Funds Rate. 52 Like the BOJ, in 2008 it began paying interest on excess reserves, with no specific action on a bank’s part needed to “deposit” them. In principle, the rate paid is 3/4 percent below the target Federal Funds Rate, although from the inception of this new mechanism through the time of writing the near-zero level of the target rate has rendered the matter moot. (As part of the same 2008 change, the Federal Reserve also began paying interest, at the target Federal Funds Rate, on required reserves; because each bank’s required reserves are predetermined as of the beginning of the maintenance period, this payment has no impact on banks’ management of their reserve positions within the maintenance period. From this perspective it is merely a lump-sum transfer to the banks.) Finally, although there is no evidence of systematic changes in reserve supply to effect movements in the central bank’s policy interest rate in any of these three systems, in each one the central bank does intervene in the market on a regular basis in response to either observed or anticipated deviations of the market interest rate from its target. Both the Federal Reserve and the BOJ conduct open market operations once per day, normally at the beginning of the day. The ECB does so only once per week

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