Federal Funds Rate

The Federal Funds rate (often abbreviated Fed rate ) is the interest rate at which U.S. financial institutions ( including banks and savings banks) lend money to each other to compensate for their balances from the minimum reserve requirements at the central bank. Since this happens every day, we also speak of overnight credit ( German literally overnight credit ). The effective (actual ) interest rate may differ from the nominal, which is why mainly open-market operations are used to control and compliance with the formulated as a monetary policy target nominal interest rate.

When we talk in the media believe that the U.S. Federal Reserve (Fed) has changed its key rate, the federal funds rate is meant as a rule.

• 2.1 Effect of changes in the Federal Funds Rate
• 2.2 Example

Method

Reserve holdings

U.S. banks are required by law to hold certain interests in reserves. Alternatively, these may be kept in interest-bearing cash reserves or cash at the Fed. The share of the reserves is set by the Fed on the stock of assets and liabilities of each financial institution. Are usual 10% of the total value of demand deposits.

When a U.S. financial institution provides a loan in the ordinary course of business, it reduces his money and thus its reserve. If this reserve percentage falls below the required reserve ratio, the bank must increase according to the requirements of Fed their reserves. The Bank may borrow the required capital of another bank, which has a surplus reserves at the Fed. The interest rate that the borrower can bank the lending bank pays is negotiated in the interbank market. This weighted average of this rate for all transactions between banks is called the effective federal funds rate.

If the Fed to a " change rate" refers, thus, making it almost always meant the nominal interest rate, which is determined by the governors of the central bank as a target. The actual federal funds rate is determined by open market operations and is within a target range, which is set by the governors of the central bank.

Another way in which banks can borrow to maintain their required reserves to capital, consists in taking a loan from the Fed. This loan is subject to supervision by the Fed. This discount rate is normally higher than the federal funds rate. The differences between these two types of loans often lead to confusion between the federal funds rate and the discount rate. Another difference is that the Fed funds rate is not exact, but it can set a specific discount rate.

Control of the federal funds rate

The goal of the federal funds rate is set by the Federal Open Market Committee (FOMC ). Depending on the agenda and the economic situation of the United States, increase or decrease the FOMC members to rate or leave it unchanged. It is possible to make a prediction about market expectations of FOMC decision. This happens at the meetings of the Chicago Board of Trade ( Chicago Board of Trade, CBOT ). In the financial media reports on the probabilities of the Fed Funds futures contracts.

Applications

Interbank transactions ( money lending between banks ) are an easy way for banks to raise capital quickly. For example: A bank wants to give an industrial company a larger loan, but she has not the time to wait for deposits or loan payments. Then she can borrow this amount from other banks quickly and easily.

Impact of changes in the Federal Funds Rate

Increases the federal funds rate, banks will be advised to include inter-bank loans, since then " expensive " is to raise this money. On the other hand, the interest rate falls, banks are encouraged to borrow money. The "cheap" become money should revive the investment and consumption activities in order to support the economy. However, a cut in interest rates may also act as an inflationary and thus inflationary. Despite the short notice available options, monetary policy is economically more of a medium-to long -term impact. However, not to be underestimated is the psychological effect on the signal market participants, momentarily affect the already investment and consumption decisions.

This interest rate acts as a regulatory tool to control the free U.S. economy. The consequence of this is that a certain interdependence with the world economy exists.

By the Fed sets a higher discount rate, banks are discouraged to borrow money from the Fed. However, it reserves as a last resort, to spend money.

Example

In the following example, the relationship between the federal funds rate and its effect is explained in more detail on the economy.

If the interest rate increases, the turnover of the company, reduced by a decline in consumer behavior is. This effect is not immediate. Rather, it is a gradual process, which reached its maximum extent until after about 1 to 1.5 years. This suggests that companies need to scale back their production due to the drop in sales. This reduction in production is slower, so that they become apparent only after about 2 years. Due to the decline in production also employment, which is reflected in an increase in the unemployment rate reduces ..

It can be seen from the following example, that monetary policy has an effect on the economic agents. But one also sees that this is a short-to medium -term process.

Comparison with the LIBOR

Although the London Interbank Offered Rate (London inter-bank selling rate, LIBOR) and the federal funds rate have the same function, ie regulate interest rates in interbank loans, they are different in a few ways:

• The (target) Federal Funds Rate is an interest rate that is set by the FOMC and U.S. monetary policy governs.
• The effective federal funds rate is calculated from the usual interest rates of banks, which are under the supervision of the American authorities.
• LIBOR is calculated from the standard interest rates of banks in London. There is not the same reserve requirements as a significant difference.
• Federal Funds rate is achieved through operations on the "Domestic Trade Desk " in the " Federal Reserve Bank of New York " ( Bank of New York), mainly in domestic securities acts (government bonds and securities of the federal authorities ).
• LIBOR may, but need not be used to derive terms and conditions. He is not fixed in advance, but this does not mean that he has no macroeconomic background.

Predictions by the market

A change in the federal funds rate affects the value of the dollar and the amount of loans issued. This in turn has implications for new economic activities ( eg business investments). The price of the option contracts, the so-called "fed funds futures", ( traded on the Chicago Board of Trade ) can be used to infer the expectations of the market, the future Fed policy changes. Such implied probabilities are published by the Cleveland Fed.

Recent changes and historical interest trend

• On 22 January 2008, the Fed has the prime rate of 4.25 % by 75 basis points to 3.5 % lowered .. The reduction was enforced by a deteriorating economic outlook and increasing downside macroeconomic risks.
• On 30 January 2008, the Fed lowered its key rate by 50 basis points from 3.5% to 3.0%. The FOMC is to foster moderate growth and mitigate the economic downside risks. "
• On 18 March 2008, the Fed lowered its key rate by 75 basis points from 3.0% to 2.25%. This completes the unsettled by the mortgage crisis U.S. economy is supplied with cheaper money and the threat of recession can be counteracted.
• On 30 April 2008, the Fed lowered its key rate again by 25 basis points from 2.25% to 2.0%. Two members of the Federal Open Market Committee of the Fed vote against this decision.
• On 8 October 2008, the Fed lowered as part of a concerted action of central banks worldwide U.S. policy rate by 50 basis points from 2.0% to 1.5%.
• On 29 October 2008, the Fed lowered the federal funds rate by 50 basis points again from 1.5% to 1.0%.
• On 16 December 2008 it was announced that the federal funds rate to 0.0 to 0.25 % will be lowered.

Important key interest rates of the ECB and the Fed since the establishment of the ECB