I just finished reading most of “The Mystery of Banking” and “America’s Great Depression” and I just can’t seem to figure out this one thing about the Federal Funds Rate. I know that the Fed doesn’t just “set” the rate; rather it sets a target rate. In order to achieve that target rate, it conducts open market operations to manipulate bank reserves. If the Fed wants the rate lower it buys assets (more often than not government securities). If it wants the rate higher it sells them. So here is where I’m getting hung up. Let’s say for example say the Fed Funds Rate is at 5% (actual) and the Fed wants rates down to 1% (target). Is the goal to increase the amount of reserves at commercial banks or member (Federal Reserve) banks or both?What role do member banks play? Do member banks have reserves themselves and accept deposits from individuals or do they exist only to hold commercial bank reserves?So the Fed starts buying assets. What assets and from whom are they buying them? Is the Federal Reserve buying assets directly from commercial banks? All the commercial banks? Would it even have to buy assets from all the commercial banks in order to push the Fed Funds Rate down?Do they buy assets (bonds or mortgages or ?) directly from commercial banks or are do they buy bonds from the Treasury?If the Fed buys bonds directly from the Treasury, how does the money get to commercial banks? I’m assuming the Treasury would have to buy something in the private market. Then parts of the private sector would at some point deposit that money. So what does the Treasury generally buy in the private sector?I guess I’m looking for a detailed walk through of how the Fed actually gets the rate down. Anyone interested in explaining it
Let say the market determines the fed funs rate to be 3% and the Fed wants it at 2%. The FED will (with its tools) try to influence market forces to bring down the fund rates. Keeping rates artifficially low or higher. There has been reports that this is difficult to do sometimes.
If the Fed wants to lower the interest rate it will buy treasuries (loans issued by the US Treasury) from the public. They will pay for these by increasing the reserves of the commercial banks in which the seller of the treasury is a customer.
You will find this article interesting:
http://www.financialsense.com/Market/wood/2008/1031.html
It proves that the Fed doesn't have full control over the interest rates. Rather, the rate is primarily determined by the credit (treasury) market. In history, the Fed's discount rate has always followed the trend of what happens to the yield on the 3-month T-bill. However, in October 2008 for the first time the Fed artificially reduced the discount rate more than the trend of the 3/mo t-bill rate than ever before. Having said this, I don't know how much influence the Fed has on the primary trend of the 3/mo T-bill rate considering the Fed is a buyer/seller of short term treasuries just like other market participants.
Member Banks have accounts at the Federal Reserve. Banks hold US treasuries in these accounts as assets. Say I also hold US T-bills in my investment portfolio for some speculative reason, to buy/sell bills for profit. If the Fed wants interest rates to fall they really want to inject more money into the economy to supply or oversupply the demand for money and/or treasury bills - that which determines the yield on T-bills. I, and others, bought T-bills at a price of $98 (int rate =2%) and I have a sell limit set at $99 (int rate = 1%). The Fed comes in and offers $99 for any T-bills up for sale. I dump mine, as well as some banks dump theirs and enough volume is traded to shift the market yield. The 3-mo T-bill yield then falls to 1%. I and others now have cash instead of T-bills. I put my cash in my savings account and the bank lends it out. The Bank also has more cash reserves that it can lend out. The demand for money is satisfied at a lower 3-month T-bill interest rate. The Fed changes the discount window interest rate based on this shift in the T-bill rate. Also, since banks now have more cash there will be less need to borrow from each other or from the Fed. That means there is less demand to borrow from the Fed through its discount window and therefore this supports the reduced interest rate / demand of borrowing directly from the Fed.
The rate is set by a target. Just like a car's cruise control attempts to set the speed around your setting. Up hills or down hills the speed will vary around the setting, but the average speed over time is whatever your setting is. The Fed regulates the interest rate in the same way, except they're participating in the credit market by buying / selling short term T-bills on the open market to supply the demand for T-bills or cash at whatever face price they choose. Above, they wanted T-bill face price to be bid up and maintained at $99/ea so they either flood the market with T-bills or buy up all the T-bills from the market at $99/ea to keep the 3-mo T-bill rate at 1%
Thanks for the replies everyone. Sorry for not posting again sooner. After a few months, I'm understanding a bit more now. So what happens if the Fed wants the rate to go up, they try to sell treasuries, and no one is buying? How do they raise rates then?
Kevin7D: Thanks for the replies everyone. Sorry for not posting again sooner. After a few months, I'm understanding a bit more now. So what happens if the Fed wants the rate to go up, they try to sell treasuries, and no one is buying? How do they raise rates then?
Hi Kevin - remember, the lower the treasury price, the higher the interest rate.
Since at a given interest rate people are buying treasuries, raising the interest rate (lowering the price of the treasuries) will attract more buyers of treasuries, because they get a cheaper treasury with a higher yield.