What It Means When the Fed Changes Interest Rates

Posted on December 19, 2007
Filed Under Finance & Economics, Global Issues |

The Federal Reserve has been changing “interest rates” over the past few months and most people I talk to don’t know what that means or how it works.  Here is a simple explanation.

First, a basic understanding of commercial bank regulation is needed. 

Banks are required to have a certain amount of reserves in the form of vault cash or non-interest bearing reserves held with the Fed.  This is reserve requirement is determined by each banking institution’s liabilities and assets, as well as the Fed, but is typically around 10%.  That means that if a bank wants to lend out $100 it only needs $10 in the vault to do so. 

Fundamentally this doesn’t make sense since a bank should be able to provide cash to all depositors should the need arise.  However, it is not likely that ALL depositors will demand all of their money at the same time (known as a bank run).  This happened during the great depression, and is exactly why the commercial banking system is so heavily regulated today. 

Regulators go to great lengths to ensure trust in the banking system, in order to prevent another massive bank run.  The mechanisms used to provide trust in the banking system are:

1. Reserve requirements
2. A lender of last resort (the Fed)
3. Depository insurance (FDIC insured bank accounts, typically up to $100,000)

The “interest rates” that the Fed can change relate to the rate banks charge each other to meet Reserve Requirements (Federal Funds Rate) and the rate the Fed charges as a lender of last resort (Discount Rate).

At the end of each day, some banks have funds in excess of their reserve requirement, and some banks have funds that fall short of their reserve requirements.  The banks that fall short only have two ways to meet reserve requirements each night.  They can either borrow from another bank (at the Federal Funds Rate), or borrower from the Federal Reserve (at the Discount Rate).

The Federal Funds Rate is the market driven interest rate charged by banks on overnight loans to satisfy reserve requirements.  The Discount Rate is the rate that is charged by the Federal Reserve as lender of last resort.

The Fed can only set a specific rate for the Discount Rate.  It cannot set a specific rate for the Federal Funds Rate.  This is because the Federal Funds Rate is a market driven rate set by supply and demand.

So, what exactly does it mean when the Fed lowers or raises interest rates?  It means one of two things.  First, it could mean the Fed is lowering or raising the Discount Rate, which is what it charges to banks on loans.  Second, it could mean that the Fed is lowering or raising the Federal Funds TARGET Rate.

It is important to understand the nature of the Federal Funds Target rate.  The Fed cannot just make up a number and require all banks to lend at that figure.  What it does is set a target range for the actual market-driven Federal Funds Rate, and then it uses Open Market Operations to move the actual rate closer to the target rate.

This can be confusing but makes a big difference when we talk about the Fed changing “interest rates.”

This was crucial to understanding the interest rate decisions made by the Fed immediately after the Credit Crisis in August.  After the Credit Crisis, the headlines all said the Fed lowered “interest rates.”  But which one?  The actual Federal Funds Rate set by the market was unusually high, which signaled that banks were less willing to lend their capital to other institutions (because of a higher risk of doing so).  But instead of changing the target Federal Funds Rate, the Fed changed the Discount Rate.  The discount rate is higher than the Fed Funds rate, and has a stigma attached to it (no banks want to borrower from the Fed because it is seen as a sign of insolvency).  Thus, the lowering of the discount rate was largely ineffective. 

The implications of the Credit mess were still largely unknown, and the Fed was still concerned about inflation, so it decided to lower the DISCOUNT Rate, and not the Federal Funds Rate, which did not solve the problem.  But since most people didn’t understand this difference in rates, they did not understand the actual implications of this “rate change.”  Even some investment bankers I know didn’t get this.

In the following weeks the Fed finally changed its target for the Federal Funds Rate, but although the target was changed it didn’t initially matter.  There was still a large spread between the target rate and the actual rate.  And in subsequent weeks when the Fed continued to lower the Fed Funds target rate, the market rate was a few hundred basis points below the target because of all the liquidity the Fed pumped into the market!

The above is a wonderful example of the importance of understanding the distinction between the Federal Funds Rate (target and actual) and the Discount rate.  It was useful in interpreting the decision of the Fed after the Credit Crisis, and it will be important in determining the implications of the Fed as we move into 2008 with an uncertain economy.

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