LeoGlossary: Fed Funds Rate
This is also called the Effective Federal Funds Rate (EFFR)
The daily effective federal funds rate (EFFR) is calculated by the Federal Reserve Bank of New York (FRBNY) and published each day. This is is calculated as a volume-weighted median of overnight federal funds transactions.
It is the rate that depository institutions lend their excess reserves to other like institutions without having to put up any collateral. This is unsecured lending.
The NY Fed publishes the previous day's rate on their website by 9 AM.
Federal Funds Target Range
The Federal Reserve Open Market Committee gets a lot of attention for their moving of interest rates. The FOMC actually establishes a range the rates.
There are 8 meetings per year where the members decide what to do with rates. This is part of the central bank's monetary policy.
It adjusts the administratively set interest rates, mainly the interest on reserve balances (IORB), to bring the effective rate into the target range.
Calculation
The FFER is based on data voluntarily provided to the New York Fed by major fed funds brokers, and is a weighted-average rate of all overnight fed funds transactions arranged through these brokers each business day.
To get the volume-weighted median rate it is calculated by ordering the transactions from lowest to highest rate, taking the cumulative sum of volumes of these transactions, and identifying the rate associated with the trades at the 50th percentile of dollar volume.
Also published alongside the volume-weighted median rate are the 1st, 25th, 75th and 99th volume-weighted percentiles and the transaction volume underlying the rate.
Banks Requirements
Regulations are established for financial institutions. These entities require a certain amount of liquid assets to cover cash outflows. This is meant to fend off a bank run.
Banks often have reserves above the required level. Since the Fed pays interest on these, these funds might not be used in other ways. This is the Interest on Reserve Balances (IORB). The Fed did not always pay this.
One use of excess reserves is to lend them to other depository institutions. Financial institutions often find themselves having a shortfall since settlement often takes a few days.
Reserves for depository institutions are made up of two things. This includes deposits from customers, showing as a liability on the balance sheet. The cash is on the asset side. This helps them to meet the reserve requirement.
The other aspect (outside of vault cash which are banknotes and coins) is central bank reserves. These are liabilities on the Fed's balance sheet and on the asset side of the commercial bank sheets.
Effect of Quantitative Easing
Most of the major central banks have engaged in Quantitative Easing (QE). This is a swap of central bank reserves for securities, mostly US Treasuries and mortgage backed securities (MBS). It is an accounting maneuver done as part of the central bank's monetary policy.
When they are easing, they are trying to push down interest rates by restricting the supply of bonds on the market. The hope is the supply and demand equation being adjusted will force prices up, thereby lowering the rates.
From the central bank perspective, there is an important distinction. Securities held by the depository institution are not part of the reserves. The US banking system operates under fractional reserve banking. This means that banks only hold a portion of their deposits in cash. Securities do not figure into this at all.
Since there is a multiple on lending, having higher reserves means banks can, in theory, make more loans. This is the concept behind QE. By removing the securities from the balance sheets of banks and replacing it with reserves, the banks lending ceiling is raised.
The problem with this is banks tend not to lend when the economy is slowing. They get conservative with their practices, usually raising lending standards. All of this goes counter to what the Fed is trying to do.
Banks will opt to either collect the Interest on Excess Reserves (IOER) or lend to each other. This is where the Federal Funds Rate comes in.
Inter-Bank Lending
The Federal Funds Rate is the cheapest form of lending. This is even less than the discount window, which allows commercial banks to borrow directly from the Fed.
Why would banks want to borrow money from each other?
Probably the primary reason is to meet the reserve requirement. It is not uncommon for a bank to experience unbalanced cash flow. When the liquid asset total falls below the reserve requirement, the bank has to raise more money.
One approach would be to do a capital raise. This is a slow process and one that gets investors upset. If the situation is long term, this is a path that is often taken. There are time the regulators require banks to do capital raises.
The other option is simply to borrow the money from another bank. This is where the overnight lending market starts. As banks take steps to remain in compliance, a series of transactions are set off. The agreed upon rates for all the different loans is what the Federal Reserve Bank of New York compiles and weighs.
Effect On Other Rates
The markets watch the Fed's announcement regarding the Fed Funds Rate. This is something that affects all interest rates.
When the rate is raised, all other assets follow suit. This applies to mortgages, car loans, and credit card payments. In effect, the Fed is making the cost of money go up.
The reverse is also true.
When it comes to the yield curve, the short end is impacted by the Fed's actions more than the longer dated bonds. It is the latter where it is believe the bond market shows it viewpoint.
Irving Fisher, a century ago, wrote how the long end of the yield curve reflected the market's expectation on both growth and inflation. It the curve is upward slopping, the market is in agreement with the Fed.
Things change when the yield curve starts to flatten, or worse, inverts. This is the result of the long end moving less (or not at all) in response to the Fed's increases.
Private interest rates also follow suit. The 30 year mortgage rate might move less than the Fed Funds Rate if the perceived actions are misaligned with the economic view going forward.
