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FEDERAL RATE CUT

AND IT’S IMPLICATIONS

(MACRO ECONOMICS)
MMS-I March 2008

By

LOONY and Group


FEDERAL FUNDS RATE

In the United States, the federal funds rate is the interest rate at which
private depository institutions (mostly banks) lend balances (federal funds)
at the Federal Reserve to other depository institutions, usually overnight.
Changing the target rate is one form of open market operations that the
Chairman of the Federal Reserve uses to regulate the supply of money in
the U.S. economy.

All banks are subject to reserve requirements, but they frequently fall below
requirements in carrying out of day-to-day business. To meet requirements
they have to borrow from each other's reserves. This creates a market in
reserve funds, with banks borrowing and lending as needed at the federal
funds rate. Therefore, the federal funds rate is important because by
increasing or decreasing it, over time, the Fed can impact practically every
other interest rate charged by U.S. banks

MECHANISM

U.S. banks and thrift institutions are obligated by law to maintain certain
levels of reserves, either as non-interest-bearing reserves with the Fed or
as vault cash. The level of these reserves is determined by the outstanding
assets and liabilities of each depository institution, as well as by the Fed
itself, but is typically 10% of the total value of the bank's demand accounts.
For example, assume a particular U.S. depository institution, in the normal
course of business, issues a loan. This dispenses money and reduces the
bank's reserves. If its reserve level falls below the legally required
minimum, it must add to its reserves to remain compliant with Federal
Reserve regulations. The bank can borrow the requisite funds from another
bank that has a surplus in its account with the Fed. The interest rate that
the borrowing bank pays to the lending bank to borrow the funds is
negotiated between the two banks, and the weighted average of this rate
across all such transactions is the effective federal funds rate.
The nominal rate is a target set by the governors of the Federal Reserve,
which they enforce primarily by open market operations. When the media
refer to the Federal Reserve "changing interest rates," this nominal rate is
almost always meant. The actual Fed funds rate generally lies within a
range of the target rate, as the Federal Reserve cannot set an exact value
through open market operations.
Another way banks can borrow funds to keep up their required reserves is
by taking a loan from the Federal Reserve itself at the discount window.
These loans are subject to audit by the Fed, and the discount rate is
usually higher than the federal funds rate. Confusion between these two
kinds of loans often leads to confusion between the federal funds rate and
the discount rate. Another difference is that while the Fed cannot set an
exact federal funds rate, it can set a specific discount rate.
The federal funds rate target is decided at Federal Open Market Committee
(FOMC) meetings. Depending on their agenda and the economic
conditions of the U.S., the FOMC members will increase, decrease, or
leave the rate unchanged. It is possible to infer the market expectations of
the FOMC decisions at future meetings from the Chicago Board of Trade
(CBOT) Fed Funds futures contracts, and these probabilities are widely
reported in the financial media.

OPEN MARKET OPERATIONS


Meaning: Buying and selling of government securities in the open market in
order to expand or contract the amount of money in the banking system.
Purchases inject money into the banking system and stimulate
growth while sales of securities do the opposite.
The Federal Reserve has three main mechanisms for manipulating the
money supply:

1. It can buy or sell treasury securities. Selling securities has the effect
of reducing the monetary base (because it accepts money in return
for purchase of securities), taking that money out of circulation.
Purchasing treasury securities increases the monetary base
(because it pays out hard currency in exchange for accepting
securities).
2. Secondly, the discount rate can be changed.
3. And finally, the Federal Reserve can adjust the reserve requirement,
which can affect the money multiplier; the reserve requirement is
adjusted only infrequently, and was last adjusted in 1992.

The federal funds rate target is decided at Federal Open Market Committee
(FOMC) meetings. Depending on their agenda and the economic
conditions of the U.S., the FOMC members will increase, decrease, or
leave the rate unchanged.
In practice, the Federal Reserve uses open market operations to influence
short term interest rates, which is the primary tool of monetary policy. The
federal funds rate, for which the Federal Open Markets Committee
announces a target on a regular basis, reflects one of the key rates for
interbank lending. Open market operations change the supply of reserve
balances, and the federal funds rate is sensitive to these operations. In
theory, the Federal Reserve has unlimited capacity to influence this rate,
and although the federal funds rate is set by banks borrowing and lending
funds to each other, the federal funds rate generally stays within a limited
range above and below the target (as participants are aware of the Fed's
power to influence this rate).

The Fed constantly buys and sells U.S. government securities in the
financial markets, which in turn influences the level of reserves in the
banking system. These decisions also affect the volume and the price of
credit (interest rates). The term open market means that the Fed doesn't
independently decide which securities dealers it will do business with on a
particular day. Rather, the choice emerges from an open market where the
various primary securities dealers compete. Open market operations are
the most frequently employed tool of monetary policy.

HOW OPEN MARKET OPERATIONS ARE CONDUCTED IN THE USA

In the U.S., the Federal Reserve (Fed) most commonly uses overnight
repurchase agreements (repos) to temporarily create money, or reverse
repos to temporarily destroy money. Alternatively, it may permanently
create money by the outright purchase of securities. Very rarely will it
permanently destroy money by the outright sale of securities. These trades
are made with a group of about 22 banks or bond dealers who are called
primary dealers.
Money is created with a repo simply by electronically increasing the reserve
account at a bank that is by issuing a new liability of the central bank.
Money is destroyed with a reverse repo simply by decreasing the reserve
account of a bank that is by destroying a liability of the central bank. The
Fed has conducted open market operations in this manner since the
1920's, through the Open Market Desk at the Federal Reserve Bank of
New York, under the direction of the Federal Open Market Committee.
Increasing the required reserve ratio reduces the lending ability of banks
thus contracting money supply. Another way is the outright sale of
government securities, which are paid with bank reserves, thus contracting
Money Supply. The Fed buying securities pumps in cash into the system
via the required reserve ratio, thus expanding Money Supply.

APPLICATIONS
Interbank borrowing is essentially a way for banks to quickly raise capital.
For example, a bank may want to finance a major industrial effort but not
have the time to wait for deposits or interest (on loan payments) to come in.
In such cases the bank will quickly raise this amount from other banks at an
interest rate equal to or higher than the Federal funds rate.
Raising the Federal funds rate will dissuade banks from taking out such
inter-bank loans, which in turn will make cash that much harder to procure.
Conversely, dropping the interest rates will encourage banks to borrow
money and therefore invest more freely. Thus this interest rate acts as a
regulatory tool to control how freely the US economy, and by consequence
world economy, operates.
By setting a higher discount rate the Federal Bank discourages banks from
requisitioning funds from the Federal Bank, yet positions itself as a source
of last resort.

PREDICTIONS BY THE MARKETS

Considering the wide impact a change in the federal funds rate can have
on the value of the dollar and the amount of lending going to new economic
activity, the Federal Reserve is closely watched by the market. The prices
of Option contracts on fed funds futures (traded on the Chicago Board of
Trade) can be used to infer the market's expectations of future Fed policy
changes. One set of such implied probabilities is published by the
Cleveland Fed.

HISTORICAL RATES
As of February 11, 2008, the most recent change the FOMC has made
to the funds rate was a 50 basis point cut from 3.5% to 3.0% on
January 30, 2008. This followed the unusually large 75 basis point cut
made during a special January 22, 2008 meeting in response to the
stock market turmoil that January.

IMPACT OF FEDERAL RATE CUTS

The Federal Reserve has responded to potential slow-down by lowering


the target Federal funds rate during the recessions and other periods of
lower growth. In fact the Federal Reserve lowering has recently predated
recessions. The charts show the impact on S&P500 and short and long
interest rates.

June 29, 2006- (Jan. 30 2008): 5.25-3.00

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