The most common news to come out of the Federal Reserve is the result of FOMC meetings and changes to the Federal Funds Rate. Jerome Powell has made news with his aggressive rate hikes that some fear will topple the economy. However, how they raise and change the Federal Funds Rate has changed over time. If one is to offer proper analysis of the Fed’s actions, we must be able to properly understand what its tools are, and how they have changed over time. The fitting target to observe is the Federal Funds Rate above.
The Federal Funds Rate is important to define in understanding it. It is often referred to as “the Fed raising interest rates,” and this is not totally inaccurate. The Federal Reserve setting the Federal Funds Rate can affect consumer credit markets. But what is it?
The Federal Funds Rate is a benchmark rate, more accurately a target range for a rate, that banks charge for overnight lending of reserves. Banks in the United States operate on a fractional reserve model, where they loan out their deposits whilst maintaining the illusion, they can meet all the demands of their depositors. Accounts at such a bank are called demand deposits, and the banks play a dangerous game maintaining only a fraction of their reserves (hence the term “fractional reserve”) hoping depositors won’t withdraw all their deposits at once.
The game relies on the bank having enough reserves to meet any day’s deposit demands and not too little. Having too little means some demands will go unmet and a bank run will result. All depositors will rush to get what is left of their deposits and the bank will go under as it tries to fulfill all the demands.
Banks generally set a reserve minimum, that they assume will be satisfactory to meet day by day deposits. If a bank has what might be called excess reserves, it will often loan the excess to banks that are not able to meet their depositor demands. The Federal Funds Rate is simply the target the Fed sets for a minimum interest rate charged between banks that engage in lending overnight.
This affects short-term loans, as any additional loans come out of excess reserves. Raising the Funds Rate makes lending more expensive for banks and thus consumers, and vice versa.
The means for establishing the range have changed over time as the Fed has adapted its tools. In the past the Fed would use Open Market Operations to buy assets from a bank. If a bank owned, say, a treasury bond the Fed might buy that bond and deposit dollars into that bank’s Master Fed Account. This increases excess reserves and lowers interest rates. When more reserves, not reflective of true savings, enter it will drive down the interest rates. When the Fed sells an asset to a bank it removes dollars from the Fed’s accounts. This raises interest rates as the reserve amount becomes scarcer.
After the Financial Crisis, how the Fed established the rate changed. Rather than buying or selling assets, it offers interest on reserves. This essentially establishes a floor for interest rates. The Fed offers interest on reserves parked at the Fed overnight in a Fed Master Account. Why would a bank loan out their excess reserves at a rate lower than what they can get by parking it at the Fed. The Fed doesn’t carry the risk that a commercial bank does. But this can be confusing, and analogies help to teach how this works.
If we want to understand the original method of Open Market Operations, a helpful comparison is a video game: Flappy Bird. The story of the game, which is worthy of its own article, is not important so much as the mechanics of the game. The way Flappy Bird works, the player taps on the screen which moves the bird up. By releasing your finger from the screen, the bird falls. The goal is to weave the pixelated bird into the opening between pipes. How does this apply to the Fed?
Much like the bird deals with upward and downward pressures, so do banks under the traditional open operation method. The Fed buys assets, applying an upward pressure to interest rates, and sells them to apply downward. The Fed is the player of Flappy Bird, tapping on the screen to move the bird (the Federal Funds Rate) or letting go (selling assets) to let rates fall.
An odd analogy to say the least, but one that younger future economists can understand.
We can apply a similar analogy to understand the new Federal Funds Rate mechanism post-2008. The mobile video game for this mechanism is called Geometry Dash. Another game adored by younger generations! The point of this game is controlling a square, and tapping the screen as it runs along a horizontal map, jumping over obstacles. Now this may seem similar, but the trick is the arrangement of this map.
The game forces the cube to run along the bottom of the map and hop upwards to avoid obstacles. The floor that the cube runs along provides a lowest point that the cube can be at. This is like the floor provided by interest on reserves. The cube is the interest rate, and it must rest above and cannot go below the interest on reserves. It can go higher at times, but it has a floor to run along.
It is easy to criticize the Fed based upon talking points. It is another thing to understand how it works. The Fed has an immense effect on the economy, and we had best understand it. That involves understanding the tools it uses to play surgeon with the economy. While they change over time, we can properly understand with a few analogies and some careful analysis.