Fed Funds Rate; Who Cares?

People who care about financial markets have speculated about the effects of the Fed “raising” the fed funds rate. Would it cause the stock market to decline? Would the economy return to recession? Would mortgage rates start to rise and kill the housing recovery?

A person does not need a plethora of charts and graphs to gain a basic understanding of relationships between fed actions, fed funds rates, financial markets, and economic activity.

First, the Fed does not “set” interest rates in any market, including the fed funds market. Interest rates consist of the ratio of future money to current money. As a ratio— calculated from two independent variables — an interest rate is a dependent variable. It cannot be set or determined directly. One or more of the dependent variables must change in order for an interest rate to change.

Second, participation in the fed funds market is limited to financial institutions that have accounts with the Fed. As a closed market the total number of dollars borrowed equals the total number of dollars lent. Net lending in the fed funds market equals zero. Thus, the level of total excess reserves does not affect rates. It’s the interbank imbalances in reserve accounts that cause fed funds borrowing. So what determines interest rates?

Third, because of the closed nature of the fed funds market, the Fed funds rate is determined by the relative levels of excess reserves between banks in the system. To discover the determinants of fed funds rates, you need to examine the factors that affect those relative excess reserve balances.Those factors can include: Fed open market activities, which either increase or decrease excess reserves in individual banks; the demand for bank funds (i.e. deposit liabilities); or the willingness of banks to create more deposits for the purchase of notes.

Fourth, with a banking system awash in excess reserves, what would cause rates to change? How many securities would the Fed need to sell to have the slightest effect on the fed funds rate? A lot. Simply announcing a rate hike does not change that. The Fed funds rate is zero because banks don’t have a need for reserves. Fed action has not changed that.

I will address, in more detail, questions raised by my comments above in future posts.


Flocking Markets

(Flocks of birds) have a lot to teach us about the behavior of markets and other complex living systems, e.g. individual humans, neighborhoods, markets and a flock of birds.

What does a flock of birds have to do with markets?

Probably not a whole lot.

But, they do have a lot to teach us about the behavior of markets and other complex living systems, e.g. individual humans, neighborhoods, markets and a flock of birds.

Flocks of birds, like the one in this video, consist of ten, hundreds, and maybe thousands of bird, each acting individually without external controls. Yet, they perform these amazing, intricate, maneuvers without crashing into one another. Does that mean that these bird-brains study massive instruction manuals full of rules? Do they have flight controllers in a tree near by, guiding their every move with broadcast signals?

It seems that very simple rules can guide these complex systems. Students of complex systems have built computer models that emulate the flocking behavior. Without the benefit of interviewing the participating birds, modelers have succeeded in building models that behave very much like flocking birds with only a few simple rules. One such model uses only three rules:

1. Separation – avoid crowding neighbors (short range repulsion)
2. Alignment – steer towards average heading of neighbors
3. Cohesion – steer towards average position of neighbors (long range attraction)

See description of Flocking Behavior.

Might the people who believe that markets require extensive regulation and supervision — to prevent crashes and collisions — have it all wrong? Could markets — composed of large numbers of individuals acting in their own self-interest, just like the birds — operate far more efficiently than the highly regulated markets we have today.

Consider three possible rules:

1. Live your life and allow others to live theirs.
2. Exercise your liberty by taking responsibility for your actions and expect others to do the same.
3. Do what you want with your own property and leave other people’s property alone.

Oh, of course, that would not work. People all have such self-destructive tendencies. Markets require outside intervention — and lots of it. After all, the market participants don’t have the mental capacity of birds.

A New Beginning

More than a year ago I cleaned out all of the entries in The Free Market Center Journal. At the time, I believed that, after a short hiatus, I would again start posting relevant articles. But, I ran into one delay after another; so, this blog has lain dormant for far too long.

I found during that period that I did not lack for topics about which to write. On the contrary, for a blog about free markets, I found entirely too much material. In the current economic and political climate, free markets and liberty seem like only a dream. But, I have not lost all hope.

Amongst the din of interventionist rhetoric, if you listen carefully, you might hear a few small voices calling out to release markets from the grip of government and other forms of interference. I hope, with blog posts on this site, to add one more voice to the call for clear thinking about markets and economics.

I have not yet established the pattern with which I will make posts on this blog. I will probably start with short, intermittent, posts, and eventually developer routine that includes daily posts and some themes that I will follow over a period of time.

In addition, I will develop the appearance of this blog to complement, and not compete with the content. So, you may see a bit of a different look from time to time, until I have enough content to see what works best.

Welcome, to anyone reading this, and I hope you will find the contents more meaningful with future posts.