7. What are Fed Funds?

“My view is that monetary policy should avoid deliberately stoking the risks that come with overheating the US economy and instead, slowly raise the federal funds rate to promote maximum employment commensurate with the economy’s long-run potential to increase production.”

 

What are Fed Funds?

Fed Funds are overnight loans from one bank to another bank. It is not the rate at which the Federal Reserve Bank (America's central bank) is lending money an American bank.

Earlier I wrote that banks make a profit by lending long and borrowing short (lending long= give away credit for a mortgage; borrowing short= receiving deposits from customers), that was a lot more profitable when we had higher interest rates but it's still the basic concept of what banks do. To be able to do this banks need to make sure to always meet their current liabilities. Banks can’t take all the money from their clients and put it into one big project that takes 10 years to pay back the investment because chances are high that the clients need their money within the next 10 years. Nevertheless, banks put most of our money into long term loans/investments.

Normally, banks do not need to borrow money to give me a loan to throw my party instead they take the money that a customer, let’s call him grandfather Joe has put in his deposit account, thinking it would lie in a safe, locked up, waiting for him.

 

Instead, the bank gives this money to me, without even telling grandfather Joe that his money is financing my party. I take out the loan for one year. Now imagine grandfather Joe wants to buy a big present for his granddaughter turning 18. He goes to his bank and takes out his money.

Suddenly the bank faces a liquidity risk due to the high cash outflow, in consequence, my bank goes to another bank and borrows money at the overnight fed funds rate. Normally banks borrow overnight but they can extend this period.

Why is it called FED Funds rate?

Correspondingly, they only borrow money from banks that are members of the Fed and they exchange the money through the reserves sitting at the Fed. That is the reason why banks are not afraid of giving away long-term loans because they know, they have bank buddies who can help them out and it’s a win-win situation, because the surplus bank that has too much money, can earn interest giving out a loan and the deficit bank can pay its liabilities. Of course, that only works to a certain degree. If the bank buddies are not trusting my bank anymore, as a result of not keeping promises, they will stop borrowing money or set a higher interest rate.

The central bank influences this market. The Fed promises to pay 0.25 basis points if banks leave their money at the Fed. Therefore the Fed funds rate can not get lower than 0.25 basis points. Why? Because nothing is more secure than leaving your money at the Fed. That's why you would at least charge another bank 0.26 basis points because it is riskier to loan money to another bank than leaving it at the Fed.

The Fed sets a ceiling and a floor for the Fed Funds rate. The ceiling is the high rate at which you can borrow money directly from the Fed, if you are solvent to help banks that are going through hard times. The floor is the rate of 0.25 basis points you get for leaving your money at the Fed. There are also other ways to get funding for example in the Repo market, which is explained in my next post.

 

Financial Times Quote: The Fed Funds rate is the hot topic right now because the Fed just raised interest rates. The Fed put a floor on the Fed fund rate with 0.25 basis points. If the Fed raises this rate, it becomes more attractive to leave money at the Fed instead of giving it away and taking the risk that a bank can not pay it back. Less credit slows down the economy, but the American Economy is doing quite well right now and if a central bank has high interest rates it has the possibility to lower them if the economy is not doing too well.

Introduction

The first article: The hierarchy of money

The second article: Why do we need banks?

The third article: Why we need a central bank?

The fourth article: How can banks create money out of thin air?

The fifth article: Why do we need central banks especially in a crisis?

The sixth article: What are clearing houses?

 

The eighth article: What are dealers, brokers and repos?

The ninth article: Quantitative easing and open market operation

The tenth article: Eurodollars

The eleventh article: Discounts, Discounts, Discounts

The twelfth article:  Why dealers provide liquidity

Written by: Philine Paschen

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