how the fed chooses the federal funds interest rate target hal w. snarr

How the Fed chooses the

Federal Funds Interest Rate

Target

Hal W. Snarr

The Beverly Hillbillies and Banking

• In season 1, Jed had $25 million in Drysdale’s bank but by episode 10 in season 3 it amounted to $45 million, meaning Jed received an annual rate of interest of about 25%.

• The Clampetts believed Jed’s money was safe and sitting idly in Milburn Drysdale’s bank vault

• The Clampett’s did not understand that bankers lend most of the money in savings accounts to borrowers at interest rates that exceed the interest rate paid to savers.

• In episode 10 of season 3, Granny withdrew her share ($11 million) from Drysdale’s bank to deposit it in Merchants Bank. – Drysdale could not cover this one-day withdrawal because a majority of

the money in saving accounts is lent out to borrowers.– After Drysdale told Jed that he did not have $11 million in cash in his

vault, Jed asked to look inside Drysdale’s vault.– Because the money wasn’t physically in the vault, Jed and his kin

thought Drysdale spent the money and transferred their funds to the Merchants bank.

– Later after visiting the Merchants Bank, the Clampetts asked to see their $45 million.

– When John Cushing, president of Merchants bank, said he didn’t have it (for the same reason Drysdale didn’t have it), the Clampetts transferred it back to Drysdale bank.


• By law, Milburn could not lend out all of Jed’s money because banks are/were required to hold a percentage of savings deposits as reserves (this percentage is called the Reserve Requirement Ratio).

• If Milburn was faced with a reserve requirement ratio of say 10%, Milburn could lend out all but $4.5 million of Jed’s $45 million savings deposit.

• Milburn pacified Granny every time she felt slighted by “city folk” or Milburn’s pampered, snooty, high-society wife because the Clampetts would have loaded their $45 million on the back of their old flatbed truck back to move back to Bugtussel.


• A withdrawal of $45 million would have forced Milburn to borrow funds from other banks (this is done in what is called the federal funds market) to cover his reserve requirement.

• Banks like the Merchants Bank may have excess reserves to lend banks that do not have enough reserves to meet their reserve requirement

• Milburn wanted to avoid having to borrow federal funds from the Merchants Bank because he’d have to pay interest to John Cushing, the president of Merchants Bank

• This interest rate is called the federal funds rate.


• The federal funds rate is the interest rate at which banks lend balances at the Federal Reserve to other banks overnight

• The federal funds rate target is set by the Federal Open Market Committee (FOMC)

• Currently, Ben Bernanke chairs the Federal Reserve Board and the FOMC.

• Click on the following link to learn more about the FOMC

http://www.federalreserve.gov/fomc/fundsrate.htm


http://www.federalreserve.gov/fomc/fundsrate.htm

• If the FOMC decides to lower the target rate to avoid a recession, the New York Federal Reserve Bank lowers the actual federal funds interest rate by purchasing US Treasury bonds, notes, and bills from banks.

• Conversely, If the FOMC decides to raise the target rate to avoid rising inflation, the New York Federal Reserve Bank raises the actual federal funds interest rate by selling US Treasury bonds, notes, and bills to banks.

• US Treasury bonds, notes, and bills are constantly being sold and purchased to keep the federal funds interest rate at the target rate set by the FOMC.

The Federal Funds Interest Rate and its Target

• The FOMC regularly meets to decide whether it should – keep the target at its current level because economic growth is about

3%, inflation is about 2%, and the unemployment rate is at about 5%

– lower the target to avoid recession (negative economic growth)

– raise the target to avoid rising inflation (this year inflation may be at 4% but next year it will be 6%)

• The FOMC uses inflation, economic growth and unemployment predictions to set its target use mathematical rules (e.g., the Taylor Rule)

• To make these predictions, the FOMC use statistics from variables such as sales, output, employment, etc.

The Federal Funds Interest Rate and its Target

Consumer Confidence(Consumer Comfort Index—weekly, last 5 years)

This chart shows falling consumer confidence, meaning consumer spending could fall dramatically from its current level

Falling consumer spending suggests that firms will layoff workers, increasing unemployment and decreasing economic output (negative econ growth)

Sales

3.5%

-1.5%The blue and red lines in this chart suggest the consumer spending is currently declining at a rate of about 1.5% per year.

However, the green line suggest that when automobile sales are factored out, retail sales are actually growing currently at a rate of about 3.5% a year.

The difference in these growth rates suggest that automobile sales are currently declining at a rate of about 5% per year.

-5%

Labor Market(non-service sectors)

-7%

The blue line suggests that construction jobs are currently falling at a rate of about 7% per year.


-4%

The red line suggests that manufacturing jobs are currently falling at a rate of about 4% per year.


-2%

The green line suggests that manufacturing jobs are currently falling at a rate of about 2% per year.


10%

The black line suggests that mining jobs are currently GROWING at a rate of about 10% per year.

Labor Market(service sectors)

3%

The blue line suggests that health care jobs are currently GROWING at a rate of about 3% per year.

The news in the service sectors is not as bad as it is in non-service sectors.


1%

The black line suggests that leisure jobs are currently GROWING at a rate of about 1% per year.


-1%

The red and green lines suggests that jobs in the financial and information sectors are currently declining at a rate of about 1%.

Industrial Production

The lines on this chart all suggest industrial production is declining especially in goods such as washing machines and dryers.

Capacity Utilization

If capacity turns around next month, the current recession could be over.

This chart suggests that the end of recessions occur when capacity utilization turns around.

However, capacity could turn around much later, suggesting that the recession could last much longer than expected.

Bank Lending

12%

Despite the bad news, commercial, consumer and real estate loans continue to grow.

Bank Lending

9%


Bank Lending

5%


Money

One of the mistakes the Fed made during the Great Depression was allowing the money supply to shrink.

Today, the Fed begins expanding the money supply rapidly when it perceives a recession is inevitable.

Inflation signals

The value of the Euro rose rapidlyrelative to the dollar until it leveled off last summer

As a result, the Federal Reserve feared rising inflation

Inflation fears abated after thevalue of the Euro fell relative to thedollar

Inflation signals

The price of Gold rose rapidly and then leveled off

This too created fear that inflation would begin rising too fast

Those fears abated after

Gold crashed

Inflation signals

Inflation fears eroded further as gasoline prices fell

Econ growth, Inflation, and Unemployment

Sept 2008

6.1%

The red line suggests unemployment is on the rise. It was 6.1% in September, 2008.


Sept 2008

4.9%

The blue line suggests inflation is beginning to decline. It was about 4.9% in September, 2008.


Sept 2008

0.8%

The green line suggests that the economic growth rate is falling rapidly. It was only about 0.8% in September, 2008.

Augmented Phillips Curve(monthly CPI, 1982-2008)

Dp = -0.6118x + 3.4359

R2 = 0.3076

-6

-5

-4

-3

-2

-1

0

1

2

3

4

0 2 4 6 8 10 12

Thus, inflation should

fall by about 1.6% per year

This curve demonstrates how inflation

reacts to unemployment in the economy

Suppose the Fed expects future

unemployment to rise to 8%

Unemployment rate

Ch

an

ge

in t

he

infla

tion

ra

te

Inflation

1%

With the inflation rate falls by about 1.6%,

2.6%

the Implicit Price Deflator inflation rate

should fall from 2.6% to 1% (a 1.6 percentage point decline)

-1.6%

Real quarterly GDP gap ln(GDP) – ln(GDP potential)

The red line represents full-employment output, while the blue line represents actual economic output.


When the red line lies above the blue one the economyis underperforming.


When the red line lies below the blue one the economyis overheating.


9.3699.404

Thus, the Projected GDP gap = (9.369 – 9.404)100%

Jan 2009

-3.5%

Suppose the Federal Reserve expects the gap to continue to widen

= -3.5%

Fed Inflation target

2%

Expected future inflation (GDP

Deflator)1%

Equilibrium interest rate

2%

Expected GDP gap

–3.5%

Setting the Federal Funds Rate Target

1%

Substituting in these values yields a Federal Funds rate target of

1.5 0.5 0.5( )r y yp p 1.5( ) 0.5( ) 0.51 (2 2 3 ).5 ffi

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how the fed chooses the federal funds interest rate target hal w. snarr

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