Equity Recap

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So you may have heard recently that interest rates are dropping. Mortgage rates are in the 4s and 5s, a very low rate historically. This is great news for the consumer, but it is also happening in a time of economic unrest. Is this a coincidence that rates are dropping during a slow economy? Who are setting these interest rates, and how? The answers lie in the Federal Reserve System and how it operates in enacting its monetary policy.

The Federal Reserve

The Federal Reserve System is the central banking agency of the United States. It was born out of the Federal Reserve Act of 1913 as a measure to prevent bank panics. The Federal Reserve exists today, in short, as twelve Federal Reserve regional banks, Member banks, Dealer banks the Board of Governors, Federal Advisory Council, and Federal Open Market Committee. The goals of the Federal Reserve (the Fed) are: encourage maximum employment, keep prices stable, and control interest rates. It essentially implements these goals by the use of several different methods, all of which rely on the principle of supply and demand.

                               

Method 1- Reserve Requirements

The Fed sets the minimum reserve requirements of its member banks, also known as the reserve ratio. So why does this matter and how does it affect interest rates? First, it must be known while the majority of banks in the US are not Member banks of the Fed, the total assets of Member banks are substantially larger. So most big commercial banks you have heard of, and most likely keep your money at, are members of the Fed system. The Fed controls how much in reserves these banks must have in hard currency (cash) at any given time. The more a bank must keep in reserves, the less it has available to loan out. The less cash a bank can loan out the more valuable the cash is, thus increasing interest rates for everyone. An example: The Fed increases the reserve ratio from 10% to 15%. Bank A has assets of $100 million. Thus instead of keeping $10 million in reserves it has to keep $15 million, meaning it can only lend out $85 million ($100 million- $15 million). Since there is less cash to lend out (less supply) then interest rate (price) increases. The opposite results hold true if the Fed decreases the reserve ratio. Historically the Fed uses the reserve requirement method very little in implementing monetary policy, as it causes uncertainty for banks.

Method 2- Open Market Operations

Remember how a part of the Fed is the Federal Open Market Committee? Well they are pretty important, and probably the Fed’s most valuable tool. The main way in which the Fed controls monetary policy is by open market operations. Well, what exactly does that mean? Let’s say that the current goal of the Fed is to increase economic output, and they want to do this by lowering interest rates. The Fed can do this by going to some of its Dealer banks or Member banks and executing the purchase or sell of government securities. If the Fed wants to lower interest rates then they will purchase these securities from the bank, and if the Fed wants to increase interest rates they well sell more securities. This is how it works: The Fed issues new government securities (T-bills, T-notes, T-bonds, etc) and sells them at an auction to their Dealer banks (usually large investment banks). These Dealer banks then in turn sell them on the open market, often times to commercial banks and Fed Member banks. The Fed can then come to banks holding these securities and buy them back, giving the banks cash in exchange. The bank then has more cash in reserves to lend out, and just as in Method 1 the value of cash decreases. This decrease in the value of available money causes the interest rates to decrease, thus hopefully increasing economic output.

Method 2.1- the Federal Funds Rate

This method is not an entire method on its own because it depends greatly on the Method 2. The Federal Funds Rate is the rate at which banks lend to each other, usually for very short periods of time. Ok so why does this matter and how does it affect interest rates? First remember that banks are required to keep a minimum amount of cash in reserve, usually reconciled at the end of the business day. So say that Bank A is short on reserve cash and can’t find any, they must take out a short term loan from Bank B that has excess cash in its reserve. The rate that Bank B will charge Bank A is the Federal Funds Rate. Since Method 2 has probably already determined the approximate amount that both banks have in reserves and the amount of cash in the system in total, it effectively sets the Federal Funds Rate. So if the Fed has recently purchased a lot of securities, there will be more cash in the system and the Federal Funds Rate will be lower. If the Fed did the opposite in the open market, the reverse would be true. How high or low this Federal Funds Rate is affects interest rates for the public. If the Federal Funds Rate is high, consumer loans are going to be higher and vice-versa.

Method 3- the Discount Rate

This method has a somewhat misleading name and is tied closely to Method 2.1. The Discount Rate is the rate at which banks borrow from the Fed, usually for short term periods. Like the example from Method 2.1, Bank A is again short on reserves for the day and must take out a loan to meet the minimum. They could call up Bank B and take a loan or another option is to take a loan directly from the Fed. The Fed usually doesn’t like this and wants to discourage this option. They effectively discourage that action by always setting the Discount Rate higher than the Federal Funds Rate. This results and continues the idea that the Fed is the lender of last resort to banks. The effect for consumer loans is the same as in Method 2.1. If the Discount Rate were really low, say lower than the Federal Funds Rate, then consumer loans would have lower interest rates.

Essentially these are the methods that the Fed uses to implement its monetary policy and goals. Often times this is a very delicate balancing act on behalf of the Fed due to difficult to measure targets and goals which conflict with one another. Currently some of these methods have already been enacted by the Fed to bring us out of the economic recession, and why it is a good time to be a consumer. And while the consumer may not be aware of the Fed’s actions the results certainly impact us all.