Transcript Federal Funds Rate

The Federal Funds Rate
By:
Jason Tabalujan
McIntire Investment Institute
September 10, 2002
Synopsis
 Definition
– Fed “easing” and Fed “tightening”
 Practical applications
 Current rates
 Interesting discussions
 Terms
Definition
 The overnight interest rate that banks charge one
another when they borrow from each other
 Based on a 360 day year for simplicity
 The Fed targets the funds rate – they cannot
“magically” alter market forces and change rates on the
spot
 The media publishes the targeted Fed Funds rate, not
the actual funds rate brought about by market forces
 But the targeted rate is close to the actual rate, as you
will see later
Basis Points
 Target FF rate change always quoted in basis
points
 Basis point = one hundredth of a percent
 E.g. 25 basis points = a quarter of a percent
(0.25%)
So what?

Since the Fed Funds rate is the interest rate that banks
charge each other, the lowest interest rate around
 As the “base” interest rate, the FF rate will dictate or
at least heavily influence the cost of borrowing of
businesses and consumers
 Why is the FF rate the lowest rate around?
Why lowest rate?

Because banks have to charge interest that is higher
than what they are paying at, to make money
 Since the FF rate is the rate that banks are charged
interest on, banks would not lend (to consumers and
businesses) at rates lower than the FF rate
Fed Easing
 2 perspectives
 Wall Street view – a reduction in target FF rate
 “Monetarist” economists – an increase in the
money supply
Fed Tightening
 Wall Street view – an increase in the target FF rate
 Monetarists – a decrease in the money supply
 Fed meets 8 times a year at the Fed Open Market
Committee (FOMC) to ease, tighten or leave the target FF
rate as it is. At the last FOMC meeting on August 13, rates
were left unchanged at 1.75%
Why is Tightening/Easing so important?
 When the economy is in recession, high interest
rates will negatively affect a business
 Conversely, when the economy is booming, low
interest rates can put banks out of business
 So the Fed will have to constantly balance
between the two, using economic indicators and
good judgment
Practical Applications
When interest rates are low, businesses face a
cheaper cost of borrowing, loosening up some cash
flows
 They may be able to invest in riskier opportunities
that may result in higher returns
( risk return)
 So when interest rates are low, investors can expect
an appreciation in the equity markets some time in
future (expected future value of cash flows will be
higher).
 Why doesn’t MII go long when rates are low?

Practical Applications

The key thing is knowing when cheap borrowing is
incorporated into a stock’s price – TIMING
 Even if you know when cheap borrowing takes effect
on stock prices, you may lose
 Because of other factors -- investor sentiment,
sensitivity of investor reaction to positive news,
management and efficiency of firm, etc.
Fed Watch
 Target FF rate, April 2001 – August 2002
Source: BusinessWeek.Com
Interesting Discussions
 When the target FF rate is low, the risk of inflation is
higher because money is cheaper ($1 now is worth less
than $1 in the past)
 August’s unemployment rate fell from 5.9% to 5.7%,
and national industrial production rose in July. Sign of
recovery?
Interesting Discussions
 Current target FF rate is 1.75%. If the Fed increases it
at the next FOMC meeting two weeks from today
(September 24, 2002), is it a positive sign that
businesses are more productive and better able to pay
interest on their loans?
 Would this increase investor expectations and thus be
a good time to buy?
Questions?