Federal Funds Rate the Federal Fund Rate

Federal Funds Rate

The federal fund rate was part of the solution, comprised in the Federal Reserve Act of 1913, to centralize the banking system and gain public control of the money supply, inflation, and economic growth. The banking crisis of 1907 was a result of decentralized, unregulated banking that caused confusion with private bank notes being used as currency. There were occasional episodes of monetary mismanagement where the money supply was not appropriate to fulfill the needs of the economy. Too much money caused rapid inflation where too little money stunted economic growth by hindering production and the exchange of goods and services. There were no nationally consistent banking policies and no one entity had control to implement policies until the Federal Reserve Act of 1913 became a national law.

The Federal Reserve System was created with the Federal Reserve Act of 1913 with a Board of Governors to implement and control monetary policy. The Federal Reserve Board was to provide oversight and examination of the twelve member banks (Timberlake). The oversight includes the nature and maturities of the paper and investments owned or held by the banks and could require the banks to rediscount the discounted paper, or loans to other member banks to cover liquidity requirements, at interest rates, including the federal fund rate, controlled by the board. The Federal Reserve Board had the power to suspend the gold requirements for an indefinite period.

The Banking Act of 1935 converted the regional system of reserve holding banks into a monolithic central bank with positive and deliberate control over the U.S. monetary system. One major change was the creation of the Federal Open Market Committee (FOMC). The Federal Open Market Committee is responsible for assisting the Board of Directors by directing the purchase and sell of government securities, bills, notes, and bonds. The Open Market Operations will increase money supply as the government securities are bought and decrease money supply as the securities are sold.

The federal funds rate is used to control how much the banks lend (Amadeo). The federal fund rate is the rate that banks are allowed to charge each other for overnight loans, or federal funds, to meet reserve requirements of the Federal Reserve. Each bank is required to maintain a certain balance in the Federal Reserve based on a reserve ratio set by the Federal Reserve. If some banks have access of funds, they loan them to banks that need funds to meet the requirements. The federal fund rate sets the charge to the bank obtaining the overnight loan.

The Board of Governors controls the federal fund rate. The Federal Reserve uses its status as monopoly supplier of reserves to control the federal fund rate and targets the specific rate it deems appropriate for the economy (McConnel). The rate is set for each month. The Federal Reserve then uses its open market operations to achieve and maintain the federal funds rate. The contractionary monetary policy, or restrictive, sets a higher federal funds rate that discourages banks from borrowing, which in turn discourages society to borrow because banks loan at higher interest rates causing loans to be more expensive and difficult to get as credit gets tightened. The expansionary monetary policy decreases the federal fund rate to encourage banks to borrow and lend at lower interest rates, which in turn loosens credit for consumers causing credit to become easier to obtain and allows for business expansion at reduced costs.

The FOMC observes key economic indicators in determining what the economy needs, such as the Consumer Price Index, Consumer Confidence Index, Employment, Gross Domestic Product, Interest Rate Primer, Oil Prices, and forecasts. The key indicator for inflation is the core inflation rate, which is the measurement of inflation without food and energy prices. The most important key indicator is the durable goods report, which tells long lasting, more expensive items used by business.

A one fourth point decline in the fed funds rate stimulates economic growth. Too much growth will cause inflation. A one fourth point decline in the fed funds rate curbs inflation and could cause a slowdown and prompt a decline in the markets. The FOMC changes the rate to control inflation while maintaining a healthy economic growth. The contractionary policies, or restrictive policies, cause mortgage rates to be more expensive slowing down the housing industry where society spends less. The expansionary policies cause housing to improve, mortgages more affordable, where society spends more and business expands.

The federal fund rates influences other short-term interest rates, immediately impacts the London InterBank Offered Rate (LIBOR), the interest rate banks charge each other for three-month, six-month, and one year loans, and the prime rate, the rate banks charge their best customers. It affects the interest rates paid on deposits, bank loans, credit cards, and adjustable rate mortgages. The longer-term interest rates are affected indirectly, for example if investors desire higher rate-longer term Treasury Notes. The yields on Treasury Notes drive long-term conventional mortgage interest rates. The federal fund rate indirectly affects Certificates of Deposit and auto loans, but directly affects the prime rate because banks usually add 2% to the federal fund rate to determine the prime rate. The prime rate is also a benchmark that banks use to determine other interest rates.

Lower federal fund rates create lower interest rates, which is ideal for stocks. It reduces debt expenses and encourages institutions to borrow and invest (Bofah). Higher interest rates on credit cards, mortgages, bonds, and commercial loans follow the federal funds rate. The higher interest rates increase debt payments and business costs as well as reducing corporate profits, stock prices, and adversely affecting returns.

Mortgage rates are indirectly affected by the fed funds rate because the rate only affects the lender's borrowing costs (Bankrate.com). The fed uses economic projections to determine a desired level of the federal funds rate. With gloomy economic conditions, the fed buys bonds to keep the mortgage rates low. With stronger economic conditions, the fed sells bonds to drive mortgage rates up. By selling and buying bonds, the federal funds rate maintains a desired level. The buying and selling of U.S. securities adds and subtracts from a bank's reserves to achieve and maintain a desired rate. The reserve ratio and the discount rate, the rate the Federal Reserve charges banks for loans from the Federal Reserve, are also used to control the bank's ability to lend.

Central bank activities are the most important government policies affecting economic activity (Tobin). An alternative operating procedure the Federal Reserve uses is the target of funds quantity, allowing the market to move interest rates to the level of bank demands for that quantity. The Fed's control of money markets and banks influence interest rates, asset prices, and credit flows. Arbitrage and competition spread increases and decreases interest rates the Fed controls to other markets. Stock prices fall when bond yields go up and rise when the bond yields fall. An increase in interest rates relative to other countries draws funds into dollar assets and raises the value of the dollar in foreign exchange causing increases and decreases in imports and exports.

The history of the Federal Reserve System has shown many lessons learned down through the course of years. In the late 1920's and early 1930's the Fed was not experienced for the types of events that took place. In 1927, there was no inflation in the economy (Wessel). In efforts to stimulate the economy, the Fed tightened credit and lifted interest rates. This activity led to the Great Depression, an era of stock market crashes, bread lines, bank runs, and wild currency speculation with threats of war. The economy was weakened with the absence of inflation and greater weakening occurred with the tightening of credit and higher interest rates.

During World War II and through 1951-1966, the Fed had learned to use its powers to finance the war. The Fed controlled low interest rates in order to finance the war. When bond prices dropped, the Fed would buy the securities to pump money into the monetary system. They reduced severe requirements allowing the banking system to increase its deposits proportionately and M1 money stock increased at an average rate of 2.4% and prices at 1.6%. The Fed used its power over aggregates, M1, M2, and money market conditions to influence short-term interest rates.

From 1960-1979 annual U.S. inflation increased from 1.4% to 13.3%. This shaped how Americans felt about themselves and society, how they voted, the nature of politics, how businesses operated and treated their workers, and how the American economy connected to the rest of the world (Samuelson). Americans had come to believe inflation was indestructible. While business was raising prices on goods and services, workers were demanding wage increases. Production levels were increasing, raising living standards. With low inflation from 1950-1965, annual productivity growth averaged 3.1%. When inflation rose the in the late 1960s, productivity growth slowed.

The worst inflation years were 1973-1980 when average productivity growth was 1.1%. The unemployment rate peaked at 10.8% in late 1982, which stunted the increase in living standards through lower productivity. High inflation caused the stock market to stagnate and led to a series of debt crisis that afflicted American farmers, U.S. Savings & Loan industry, and developing countries. This was a lesson that showed the high inflation created too much money for too few goods that causes a reverse the in economic growth of the country.

By 1979, there were soaring interest rates, high inflation, and a rising foreign trade deficit that led to an inactive stock market. On July 24, 1979, Paul Volcker became Chairman of the Federal Reserve (Trumbore). Volcker was determined to end inflation. He set a target for money growth, and increased the federal fund rate a full percent to 12%. This caused the Treasury bill yields to grow rapidly and bond values to decrease. By raising interest rates and tightening credit, it caused an economic slump to cut wages and increase supply and demand.

Bank prime rates had hit 21.5%, mortgage and bond rates rose, industrial production dropped to 12%, prices were rising, and wages decreased causing unions to agree to wage cuts. Volcker changed policies from past practice. Money supply was cut to curb inflation. Volcker proposed the shifting of focus from interest rates to the focus of basic money supply, focusing on M1 currency, which consists of currency, or coins and paper in the hands of the public, and checkable deposits, or all deposits in commercial banks and thrifts or savings institutions on which checks can be drawn. This would give a basic amount of reserves to the banks and through subsequent borrowing and spending would translate into a given amount of money. The idea was to squeeze the amount of money to squeeze inflation where too much money would not be chasing too few goods in an effort to create a noninflationary economic growth.

Volcker implemented credit controls, proposed by President Carter, on bank lending to businesses and consumers, including credit card debt. The controls were supposed to be designed to relieve pressure on interest rates and avoid a recession while maintaining a fight against inflation. The controls did not include home or auto loans and only had modest restraints on credit card borrowing. The effect was a decrease in inflation-adjusted consumer spending and rises in the unemployment rate. This was a lesson learned from weak control policies. It was imperative that the policies have strong controls and be enforced for maximum benefit to the economy.

The Monetary Control Act of 1980, Depository Institutions Deregulation and Monetary Control Act (DIDMCA), Title I extended the Federal Reserve's power to include all depository institutions and the eligible collateral for Fed issue of the Federal Reserve notes. Title II of the act deregulated and allowed all financial institutions to provide checking account services to customers and abolished interest rate controls on deposits. This act invited foreign customers to hold large amounts of U.S. dollars.

In July, 1982, the money supply had reached its target, so the Fed relaxed the credit controls and focused on ending the recession. The discount rate was decreased from 12% to 11.5%, with more decreases by December. The stock market went up 38.8 points. Stocks rose 50% over the next six months as investors moved money from money market funds and saving certificates. Interest rates declined and the economy started to recover. By waiting until the money supply had reached its target, the lowering of the interest rates would have a more lasting impact for the road to recovery, more especially by slow gradual reductions to the point of stability.

By driving interest rates to record highs, Volcker had cut inflation to 4% by 1983 (Madrick). The major blow that Volcker delivered to the U.S. economy caused a deep recession, an unemployment rate to 11%, countless bankruptcies with the closing of businesses, low levels of investment, government loan defaults, and near bank failures. Because Americans had come to believe inflation was indestructible, credibility had to be won by suffering for companies to understand they could no longer raise prices without consequences and workers to understand increasing wages was no longer an option. With Reagan cutting taxes and increasing military spending at the time, Volcker only increased the federal fund rate in small intervals for fear of the federal deficit's inflationary consequences. Volcker only supported campaigns that were anti-inflationary. In 1985-1990, the Fed increased the monetary base to create inflation for economic growth.

A low level of inflation is good to stimulate growth in the economy. But, when the inflation rate rises too high, it creates too much money for the amount of goods produced and creates a decline in the levels of productivity. The declining productivity causes other problems of unemployment, and debt crisis with loan defaults that result with unemployment. This is where the federal funds rate is so important for the economy. The adjustments in the federal funds rate help to keep inflation at appropriate levels in the efforts to avoid and stop problems of high inflation.

Alan Greenspan became Chairman of the Federal Reserve in 1987. Monetary policy had become a widely accepted practice being viewed as an economic lever. The FOMC was powerful and legally independent of the President and Congress. The President and Congress only had direct control when the chairman and the governors came up for reelection. Greenspan's philosophy was that inflation was the central economic concern and the emphasis was on reducing government spending and eliminating the deficit. He felt that the government spending was the source of inflation. He discarded the use of money supply data to determine policy in 1993. He disagreed with Volcker's policies and set out to change them. This brought rapid economic growth as interest rates remained low and unemployment dropped. The banks and bank like institutions were far freer from government oversight and regulatory enforcement than any time since the 1920s.