Transcript Slide 1

How the Fed chooses the
Federal Funds Interest Rate
Target
Hal W. Snarr
The Beverly Hillbillies and Banking
• In season 1, Jed had $25 million in Drysdale’s bank but by
episode 10 in season 3 it amounted to $45 million, meaning
Jed received an annual rate of interest of about 25%.
• The Clampetts believed Jed’s money was safe and sitting idly
in Milburn Drysdale’s bank vault
• The Clampett’s did not understand that bankers lend most of
the money in savings accounts to borrowers at interest rates
that exceed the interest rate paid to savers.
The Beverly Hillbillies and Banking
• In episode 10 of season 3, Granny withdrew her share ($11
million) from Drysdale’s bank to deposit it in Merchants Bank.
– Drysdale could not cover this one-day withdrawal because a majority
of the money in saving accounts is lent out to borrowers.
– After Drysdale told Jed that he did not have $11 million in cash in his
vault, Jed asked to look inside Drysdale’s vault.
– Because the money wasn’t physically in the vault, Jed and his kin
thought Drysdale spent the money and transferred their funds to the
Merchants bank.
– Later after visiting the Merchants Bank, the Clampetts asked to see
their $45 million.
– When John Cushing, president of Merchants bank, said he didn’t have
it (for the same reason Drysdale didn’t have it), the Clampetts
transferred it back to Drysdale bank.
The Beverly Hillbillies and Banking
• By law, Milburn could not lend out all of Jed’s money because
banks are/were required to hold a percentage of savings
deposits as reserves (this percentage is called the Reserve
Requirement Ratio).
• If Milburn was faced with a reserve requirement ratio of say
10%, Milburn could lend out all but $4.5 million of Jed’s $45
million savings deposit.
• Milburn pacified Granny every time she felt slighted by “city
folk” or Milburn’s pampered, snooty, high-society wife
because the Clampetts would have loaded their $45 million on
the back of their old flatbed truck back to move back to
Bugtussel.
The Beverly Hillbillies and Banking
• A withdrawal of $45 million would have forced Milburn to
borrow funds from other banks (this is done in what is called
the federal funds market) to cover his reserve requirement.
• Banks like the Merchants Bank may have excess reserves to
lend banks that do not have enough reserves to meet their
reserve requirement
• Milburn wanted to avoid having to borrow federal funds from
the Merchants Bank because he’d have to pay interest to John
Cushing, the president of Merchants Bank
• This interest rate is called the federal funds rate.
The Beverly Hillbillies and Banking
• The federal funds rate is the interest rate at which banks lend
balances at the Federal Reserve to other banks overnight
• The federal funds rate target is set by the Federal Open
Market Committee (FOMC)
• Currently, Ben Bernanke chairs the Federal Reserve Board and
the FOMC.
• Click on the following link to learn more about the FOMC
http://www.federalreserve.gov/fomc/fundsrate.htm
The Federal Funds Interest Rate and its
Target
• If the FOMC decides to lower the target rate to avoid a
recession, the New York Federal Reserve Bank lowers the
actual federal funds interest rate by purchasing US Treasury
bonds, notes, and bills from banks.
• Conversely, If the FOMC decides to raise the target rate to
avoid rising inflation, the New York Federal Reserve Bank
raises the actual federal funds interest rate by selling US
Treasury bonds, notes, and bills to banks.
• US Treasury bonds, notes, and bills are constantly being sold
and purchased to keep the federal funds interest rate at the
target rate set by the FOMC.
The Federal Funds Interest Rate and its
Target
• The FOMC regularly meets to decide whether it should
– keep the target at its current level because economic growth is about
3%, inflation is about 2%, and the unemployment rate is at about 5%
– lower the target to avoid recession (negative economic growth)
– raise the target to avoid rising inflation (this year inflation may be at
4% but next year it will be 6%)
• The FOMC uses inflation, economic growth and
unemployment predictions to set its target use mathematical
rules (e.g., the Taylor Rule)
• To make these predictions, the FOMC use statistics from
variables such as sales, output, employment, etc.
Consumer Confidence
(Consumer Comfort Index—weekly, last 5 years)
This chart shows
fallingsuggests
consumerthat firms
Falling consumer spending
confidence,
meaning
will layoff workers, increasing
unemployment
consumer
and decreasing economic
outputspending
(negative econ
could
fall
dramatically
growth)
from its current level
Sales
3.5%
-1.5%
TheHowever,
difference
ingreen
these line
growth
rates suggest
the
suggest
thatthat
automobile
sales aresales
currently
when automobile
are declining at
a rate
of
about
per
year.
factored
out,5%
retail
are suggest
The
blue
and
red
lines
insales
this chart
actually growing
currently
at a declining
rate
the consumer
spending
is currently
of about
3.5%
a year.
at a rate
of about
1.5%
per year.
-5%
Labor Market
(non-service sectors)
-7%
The blue line suggests that construction jobs are
currently falling at a rate of about 7% per year.
Labor Market
(non-service sectors)
-4%
The red line suggests that manufacturing jobs are
currently falling at a rate of about 4% per year.
Labor Market
(non-service sectors)
-2%
The green line suggests that manufacturing jobs are
currently falling at a rate of about 2% per year.
Labor Market
(non-service sectors)
10%
The black line suggests that mining jobs are
currently GROWING at a rate of about 10% per year.
Labor Market
(service sectors)
The news in the service sectors is not as bad as
it is in non-service sectors.
3%
The blue line suggests that health care jobs are
currently GROWING at a rate of about 3% per year.
Labor Market
(service sectors)
1%
The black line suggests that leisure jobs are
currently GROWING at a rate of about 1% per year.
Labor Market
(service sectors)
-1%
The red and green lines suggests that jobs in the financial and
information sectors are currently declining at a rate of about 1%.
Industrial Production
The lines on this chart all suggest industrial production is declining
especially in goods such as washing machines and dryers.
Capacity Utilization
This chart suggests thatHowever,
the endcapacity
of recessions
occur when capacity
could turn around much later, suggesting
utilization turns around. that the recession could last much longer than expected.
If capacity turns around next month, the current recession could be over.
Bank Lending
Despite the bad news, commercial, consumer and
real estate loans continue to grow.
12%
Bank Lending
Despite the bad news, commercial, consumer and
real estate loans continue to grow.
9%
Bank Lending
Despite the bad news, commercial, consumer and
real estate loans continue to grow.
5%
Money
Onethe
of Fed
the mistakes
the Fed made
duringsupply
the Great
Today,
begins expanding
the money
rapidly
Depression
allowing
the moneyissupply
to shrink.
when itwas
perceives
a recession
inevitable.
Inflation signals
The value of the Euro rose rapidly
relative to the dollar until it
leveled off last summer
Inflation fears
abated after the
value of the Euro
As a result, the fell relative to the
Federal Reserve feared dollar
rising inflation
Inflation signals
Those fears
abated after
Gold crashed
The price of Gold rose
rapidly and then
leveled off
This too created
fear that inflation
would begin rising too fast
Inflation signals
Inflation fears eroded further as gasoline prices fell
Econ growth, Inflation, and
Unemployment
6.1%
The red line suggests unemployment is on the rise.
It was 6.1% in September, 2008.
Sept 2008
Econ growth, Inflation, and
Unemployment
4.9%
The blue line suggests inflation is beginning to decline.
It was about 4.9% in September, 2008.
Sept 2008
Econ growth, Inflation, and
Unemployment
0.8%
The green line suggests that the economic growth rate is
falling rapidly. It was only about 0.8% in September, 2008.
Sept 2008
Augmented Phillips Curve
Change in the inflation rate
(monthly CPI, 1982-2008)
Thus,
inflation should
fall by about
1.6% per year
4
D p = -0.6118x + 3.4359
3
2
curve
R =This
0.3076
demonstrates
how inflation
reacts to
unemployment
in the economy
2
1
0
-1
-2
-3
-4
Suppose the Fed
expects future
unemployment to
rise to 8%
-5
-6
0
2
4
6
8
Unemployment rate
10
12
Inflation
With the inflation rate falls by about 1.6%, the Implicit Price Deflator inflation rate
should fall from 2.6% to 1% (a 1.6 percentage point decline)
2.6%
-1.6%
1%
Real quarterly GDP gap
ln(GDP) – ln(GDP potential)
The red line represents full-employment output, while the
blue line represents actual economic output.
Real quarterly GDP gap
ln(GDP) – ln(GDP potential)
When the red line lies above the blue one the economy
is underperforming.
Real quarterly GDP gap
ln(GDP) – ln(GDP potential)
When the red line lies below the blue one the economy
is overheating.
Real quarterly GDP gap
ln(GDP) – ln(GDP potential)
Suppose the Federal Reserve expects the gap to continue to widen
9.404
9.369
-3.5%
Thus, the Projected GDP gap = (9.369 – 9.404)100% = -3.5%
Jan 2009
Setting the Federal Funds Rate
Target
Substituting in these values yields a Federal Funds rate target of
i ff 1.5(
1.5
0.5p2)0.5(
0.5(y3.5y))
1%p1)  r2  0.5(
Expected future
inflation (GDP
Deflator)
1%
Expected
GDP gap
–3.5%
Equilibrium
interest rate
2%
Fed
Inflation
target
2%
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