Federal Funds Rate
While watching CNBC, I always come across this phrase “the fed is considering changing the interest rates” or “the interest rates are going to be unchanged”. I always wondered what this meant so to get back to writing after 4 years, I decided to look into one of the most important metrics that drive the US economy- the Federal Funds Rate. To understand this, we need to first understand how the banking system works in the United States.
Banking System in the United States
The Federal Reserve or the Fed is the central bank of the United States of America. The Federal Reserve website quotes its main purpose as
To provide the nation with a safer, more flexible, and more stable monetary and financial system.
One of the duties of the Fed is to supervise and regulate banks. The Fed ensures this by setting a reserve requirement.
Reserve Requirement:
The reserve requirement is the minimum amount of cash holdings that a bank is required to have at all times. This can be stored in the bank’s vaults or at the closest Federal Reserve branch. The sole purpose of the reserve requirements is to meet liabilities in the scenario when the bank is witnessing a lot of withdrawals (also known as bank run). The reserve requirement varies from bank to bank based on the reserve ratio.
Total Reserve Requirement = Total Deposits * Reserve Ratio
The Reserve Ratio is an important number as it determines the ease of bank lending. If the federal reserve lowers the reserve ratio, it means that the banks can lend more money to their customers at lower interest rates which attract borrowers. On the contrary, the federal reserve can increase the reserve ratio to stop banks from lending money to slow the economy by reducing the supply of money and thereby controlling inflation.
The reserve requirement has to be met by the banks at all times. The banks cannot lend this amount.
What if a bank fails to meet reserve requirements?
If a bank fails to meet reserve requirements, it has two options: Either borrow from the federal reserve or borrow from another bank.
If the bank chooses to borrow from the Federal Reserve, it gets charged a discount rate - Interest rate which the federal reserve charges for handing out additional money to meet the reserve requirement. These loans from the Federal Reserve are handed out on an overnight basis and are always available for any bank. The central bank holds up collateral from the bank in the form of foreign assets, bonds, and other securities.
If the bank decides to borrow money from another bank, the lending bank charges the federal funds rate as interest. These hand outs are also on an overnight basis but are uncollateralized meaning the lending bank holds no collateral from the borrower.
Typically, the discount rate is higher, but due to the pandemic, a lot has changed.
Changing the reserve requirement is heavily taxing on the banks, hence the Federal reserve rarely uses this tool. Instead, it uses alternative techniques that have a similar impact as changing the reserve requirements through open market operations.
Open Market Operations:
Before trying to understand Open Market Operations, let us first understand what is a bond.
A bond is an investment where the investor lends money to another entity for a fixed period in exchange for a fixed rate of return. At the end of the fixed interval (maturity date), the entity returns the original investment to the investor.
The Federal Open Market Committee is responsible for implementing the open market operations. The committee decides the path of the economy by buying/selling bonds to banks to regulate the bank reserves. The bonds issued by the Fed are government bonds and are considered one of the safest investments. When the federal reserve performs market operations, it could either buy/sell the bonds:
When the economy is doing well: The federal reserve sells bonds to the banks when the economy is doing well. This leads to the banks having lower cash to hand out to customers as loans causing an increase in interest rates that the banks charge while lending out money. Thus the federal funds rate increases. The primary reason why rates increase is to curb inflation.
When the economy is not doing well: The federal reserve buys bonds from the banks when the economy is not doing well. This leads to the banks having higher cash to hand out to customers as loans causing a decrease in interest rates that the banks charge while lending out money. Thus the federal funds rate decreases. The primary reason why rates decrease is to improve economic activity and investing.
Impact of Federal Funds Rate:
The federal funds rate has far-reaching implications for the market as well as individuals. One of the vital rates influenced by the federal funds rate is called the prime rate. Prime rates are the rates that the banks charge their best customers. Those customers with the highest credit scores. Generally, the prime rate is set as 3 points higher than the federal funds rate.
Credit Cards: If a credit card has a fixed interest rate, there is no impact from the federal funds rate change. For variable interest rates credit cards, a lower federal funds rate will lead to a lower interest payment on the credit card.
Savings Banks: A lower federal funds rate means bank cuts the interest handed out on savings account and hence lower interest to the consumer
Mortgages: A fixed-rate mortgage has no impact from the federal funds rate. An adjustable-rate mortgage payment will increase if the federal funds rate increase and vice versa.
Investment Portfolios: Lower interest rates cause stocks to rise while higher rates can pull stocks lower.