Fed Funds Explained

Can the Fed actually control interest rates? And, does the fed funds rate actually have a significant influence on broader market interest rates?

The financial press makes a big deal about whether the Federal Reserve will either leave the fed funds rate where it is, raise it, or get really silly, and drive interest rates below zero. In making these comments, however, they seem to assume that everyone understands the fed funds market and how it operates.

Fed Funds Redux - 16
Fed Funds Market Dynamics

Can the Fed actually control interest rates? And, does the fed funds rate actually have a significant influence on broader market interest rates?

To answer these questions one must first understand what is the fed funds market and how does it operate. To help you gain this understanding I have put together a presentation entitled “Fed Funds Explained.” You can find that presentation at this link: Fed Funds Explained.

Fed Funds Rate; Who Cares?

The Fed funds rate is zero because banks don’t have a need for reserves. Fed action has not changed that.

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.

Bye