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The Federal Funds Rate

May 22, 2015

The federal funds rate, or fed funds rate, is the interest rate that banks can borrow from each other at the Federal Reserve with overnight loans used to cover their individual reserve requirements. However, since the two banks exchanging money negotiate their own interest rate, the federal funds effective rate is the weighted average of all the rates across these transactions. How does the Fed determine the fed funds rate, and how do targets change based on both the business cycle and the desires of the Fed’s policymakers themselves? Read on for Wonk Tank’s take. 

The Federal Reserve’s Policymakers

(Image: The Federal Reserve Board Room, where both the Board of Governors and the Federal Open Market Committee meet. Source: The Federal Reserve)

The Federal Open Market Committee (FOMC) uses open market operations to manipulate the fed funds rate in order to affect the economy and move towards the ideal long-term goal, called the federal funds target rate. As the basis for all other interest rates in the economy, the fed funds rate is the primary mechanism for the Fed to affect monetary and financial conditions. When we hear the media reporting the ‘interest rate,’ the fed funds rate is what they are talking about.

People read into the Fed and the FOMC’s reports and actions hoping to predict the fed funds rate because it will undoubtedly affect all other interest rates. Historically, the fed funds rate has varied greatly: from nearly 0% recently to as high as almost 20% during the inflationary early 1980s.

Every quarter the FOMC releases projections for future GDP growth, unemployment rate, inflation, and monetary policy actions. The following graph illustrates individual policymakers’ (the Federal Reserve Board Members and Federal Reserve Bank Presidents) desired fed funds at the end of each calendar year.

(Image: Desired Fed Funds Rate by Policymaker, 2015-Long Run. Source: Federal Open Markets Committee)

How Much Do Policymakers Disagree?

In short: a lot. By the end of 2015, the major decision makers for the US economy suggest differences in up to 1.5% for what they believe to be the ideal fed funds rate. And then by 2016, that range is huge: about 3.5%. That is a lot of uncertainty.

To see just how uncertain that is, the following graph plots the effective fed funds rate since 2005 in blue and the range of desired future fed funds rate in orange.

(Image: Range of Federal Funds Rate targets by policymaker. Source: Chart compiled by Adarsh Battu from FOMC data)

Federal Funds Rate Changes and the Business Cycle

The first thing to notice is that the Great Recession was the trigger for the declining Fed Funds Rate. Another obvious observation is that the Fed Funds Rate has been nearly zero since the beginning of 2009. Just from these two ideas, it seems that the Fed’s desired interest rates indicate a prediction that there will be an oncoming economics resurgence. To test whether we can use the Federal Reserve’s desired fed funds rate as a prediction, how about we look back a few years and see if those desired rates eventually matched up to the effective fed funds rate.

(Image: Predicted Versus Actual Federal Funds Rate in 2012. Source: Chart compiled by Adarsh Battu from FOMC data)

So, the predictions at the beginning of 2012 for the end of that year were mostly wrong. That might imply that the Fed is overly optimistic about the economy’s future. However, after 2012, the Fed had much more realistic predictions. Here are the predictions in March of 2013 and 2014; remember that the points are individual members’ prediction for the end of the calendar year. 

(Image: Desired Fed Funds Rate by Policymaker, 2013-2015 and Long Run. Source: Federal Open Markets Committee, published March 20, 2013)

(Image: Desired Fed Funds Rate by Policymaker, 2014-2016 and Long Run. Source: Federal Open Markets Committee, published March 19, 2014)

As you can see, almost all of the members wanted to keep the fed funds rate at nearly zero (to stimulate the economy), which turned out to be consistent with the effective federal funds rate. Now that we have three different snapshots, we can make some interesting comparisons. Firstly, the long run target fed funds rate is consistent, which seems intuitive: it should be independent of yearly fluctuations. Notice that in 2013 and 2014, the predictions for two years out had the same or larger range than the prediction for one year out. That makes sense considering that we are less certain about future events the farther away they are. However, the March 2015 report (near the top) has a smaller range for the two-year than the one-year prediction. How can the Fed be more certain about interest rates farther in the future than just a year out? Well, the two year out also seems quite similar to the long-term target. This similarity implies that we will reach the long-term fed funds rate in the next couple of years.

Thus, the policymakers seems to be more certain that the fed funds rate should increase (to the long-term target) by 2017. 

Market Predictions for the Federal Funds Rate

All of the data so far has come from the predictions of policymakers. But many people also observe the predictions of the market because there are so many more people with different desires and sources of information. Theoretically, we would take the average of everybody’s prediction and reach a reasonable estimate for what the future fed funds rate would be. Instead of asking everybody and computing an average, we can use futures: financial products which are basically bets on what the future interest rate will be. These predictions by futures fluctuate daily, but you can find the predicted fed funds rate for the indicated date by taking 100 minus the “Last” column. For example, the market predicts the fed funds rate to be 100% - 99.68% = 0.32% by the end of 2015 (Dec-15). The mean for the policymakers’ target fed funds rate for the end of 2015 was 0.77%. So, the market is less optimistic about the economy and thinks the Fed will maintain a fed funds rate of almost zero. In general, the market predicts a lower rate than the Fed. 

(Image: Market Predictions of Future Prices and Fed Funds Rates. Source: The CME Group)

 



Sources:

http://www.federalreserve.gov/monetarypolicy/fomccalendars.htm

http://research.stlouisfed.org/fred2/graph/?g=14Et#

http://www.cmegroup.com/trading/interest-rates/stir/30-day-federal-fund.html

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  • The views expressed on the Student Blog are the author’s opinions and don’t necessarily represent the Penn Wharton Public Policy Initiative’s strategies, recommendations, or opinions.

 

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