Banking 14: Fed funds rate

So far we've talked about how the Fed can control the money supply by performing these open market transactions where they're buying and selling Treasury securities. But you're probably asking, when I read the newspaper headlines about all of this, I don't hear about the open market transactions so much and I don't hear about them buying treasuries so much. I always hear them setting the Federal funds rate, or the discount rate, or the target rate. And what do these words mean and how do these relate to open market transactions? So that's what we'll try to go over right now. So what we're going to focus on is the target rate-- and then probably in the next video or in a couple more videos, we'll focus more on the discount rate. And they're two different things, although they're often used in conjunction with each other and they move in tandem, but let's focus on the target rate because this is how the Fed, under normal conditions, normally sets its monetary policy. So, the target rate. So just so you know the definition, this is the rate that the Fed wants banks to lend reserves to each other on a very short term basis-- so, overnight. What does that mean? So I drew two banks here-- and I drew a little bit different than I normally do. The left-hand side is the assets. The red box is the liabilities and this blue over here, this is the equity. And the thing that I did different is, every video so far, I've been drawing the reserves on the bottom of the assets. And that actually made it a little confusing when you compare the reserves to the demand deposits. I'm assuming all the liabilities are demand deposits-- that they're not taking other types of loans. So these are all checking accounts, all of this red area right here. So I actually finally figured out that it would be easier to compare the reserve ratios if I had it drawn side by side. So let's say this bank right here-- these are its reserves in green-- and these could be actual dollars, this could be actual cash that's sitting in there in their vault, or it could be reserve deposits with the Federal Reserve. They're really the same thing and they can go back and forth. And I think that's kind of-- you understand that now. And just so you understand, this asset is a liability of the Federal Reserve. It's roughly that much of it. So that's that. An asset for the bank, liability for the Federal Reserve-- and this reserve for this bank is a liability to the Federal Reserve. And if these were actually cash-- if this was actually dollar bills and this would say, notes outstanding-- if this asset is a demand deposit account or reserve deposit account with the Federal Reserve, then this would just say, reserve account for bank B. With that said, so this bank, just visually the way I've drawn it-- let me just fill this in. I think looks nice when I color in the squares. This bank-- its reserves just the way I've drawn it are clearly-- its reserve ratio is clearly lower than this bank because this is its demand deposits, this is its reserves. Let's say that this bank has reserves-- I'm just eyeballing it-- looks like about if you take the ratio of this height to this height, it looks like it has reserves of maybe-- I'm just going to say 10%, while this one looks more like it has-- I don't know-- closer to 20% reserves. And now remember, banks-- we talked about regulations, so there is some minimum reserves that a bank needs to keep. And then, of course, even if there were no regulation, a bank would want to keep some reserves just in case some of these demand deposits-- people want their cash, so you always want to keep some reserves, but you don't want to keep too much reserves. Because what happens with too much reserves? Reserves-- you don't get any interest on a reserve account or on cash. And that's actually how the-- if you were curious how the Fed actually supports itself-- well, it gives these banks reserve accounts, which are essentially checking accounts at the Fed-- and it gives them no interest on it. It gives them no interest so it has no interest on the right-hand side of their balance sheets. So it pays no interest on its liabilities. And its liabilities are these things right here. It pays no interest on these things, but it gets interest on some of its assets. So here I drew a little bit of gold. This yellow part is gold right here. Let me write that-- gold. This right here is gold and then this brown color-- we'll assume that these are treasuries, right? So if I have a government treasury, it gives me some interest. So I'm paying no interest if I'm the Fed. I'm paying no interest on these reserve deposits or on these notes outstanding. And I get interest on my assets. So that's easy money and it actually turns out that what the Fed does-- and this is why it's very ambiguous whether it's really independent of the government or not. It is officially a private institution, but it's a board of directors that's appointed by the government and even more, this money that it makes, any surplus money that it has after paying all of the expenses of the Federal Reserve, it actually goes back to Congress. So don't think that somehow there's this private bank with this great money making scheme because all the money goes back to Congress. Although that goes both ways. If for whatever reason, the Fed were to do really stupid things and it were to become insolvent, Congress is obligated-- we learned before that these treasury notes are obligations of the U.S. government. So it goes both ways. So even though it's officially independent, it really isn't. It really is almost a part of Congress-- or at least a part of the government. But with that said-- actually, I should say part of the Treasury, not so much part of Congress. I don't want to be technically incorrect. But with that said, let's go back to this example with these two banks. So this guy, he probably has more reserves than he needs. And he doesn't like having too much reserves because you don't get any interest on it. Let's say that this guy-- he wants 15% reserves. He figures that that's more than enough that he needs. And this guy, he feels like he's getting a little bit low on reserves. He would also like to get to 15%. So this guy would like to borrow this much money. Reserves would actually be physical cash or reserve deposits with the Fed. And this guy, he has about this much to lend. He has roughly about this much right here to lend-- and so the obvious thing, since there's only two banks in this universe, is that this guy would lend to that guy, probably overnight because you don't know what's going to happen tomorrow. Maybe some people are going to want their money back, et cetera. So we're just lending overnight. And if this guy still feels comfortable with the situation, he can continue that lending. This guy can renew his lending and this guy will renew it-- whatever. You get the idea. So the question is, what interest rate does this guy charge to that guy for lending this little chunk of money? Let's just say right now, this bank says, well, I'll charge you-- I don't know-- I'll charge you 10% overnight. So it's not like you're paying 10% just for a one night loan. It's an annual rate of 10%. So overnight, you're paying this to the 1/365 power or however many business days there are. So it's actually a very small amount of interest. These are kind of the annual rates if this guy were to continue borrowing it overnight and overnight for a whole year. With that said, let's say that the Fed decides the money supply isn't big enough. That the Fed wants to expand the money supply. So let's see what happens in that situation. So what was that mechanism? So what the Fed does is, it can print notes. Let's just say it's actual physical cash. That's an asset that the Fed is holding now. And of course it has an offsetting liability now, which is notes outstanding, right? And then what the Fed does is, it uses these notes and it can buy treasuries, it can buy risk free government debt, right? And it buys them in the open market. That debt might be being held by China. It might be being held by your grandmother. It could be being held by anyone. It might even be being held by some of these banks, but needless to say, they take this and they buy treasuries with it. So then that asset then turns to treasuries on the Fed's balance sheet. But where did all that cash go, right? Well, that cash will then go to your grandmother who was holding the treasuries. And what is your grandmother going to do with that cash? Well, your grandmother is going to put that cash in their bank, right? And maybe they're buying it from a lot of people's grandmothers. And so let's say some of the grandmothers put the money in this bank. I'm trying to draw it. So this bank gets a little bit more reserves. And then some of the grandmothers put it in this bank over here, right? And so what happened? What was the net effect of that? The government's balance sheet increased a little bit. If you look at its total assets, it's expanded a little bit. Or if you actually just look at its total liabilities. Its balance sheet grew. It took on some treasuries-- and we'll have a whole video on what the impact on treasury interest rates that does. But in the process, when it bought those treasuries on the open market, more cash got deposited into the banking system. And this could be cash or it could be reserves with the central bank. But now let's think about this situation between these two banks. Now all of a sudden this bank here needs less money, right, because he got some reserve deposits from our grandmothers. And also, this bank-- maybe now this guy went from 10%-- maybe now he has a 12% reserve ratio because he got some deposits of actual cash. And maybe this guy went from 20% to-- I don't know-- 22%. So now this guy needs less money, right? His demand for money has been lowered, or for cash has been lowered, or his demand for reserves has been lowered. And this guy has even more to lend, right? He already had a surplus and now he has an even bigger surplus, right? So the supply of reserves has increased in the banking system. The supply his increased from the lending bank and the demand from the borrowing bank has lowered. So now for this transaction to occur, the demand has gone down, the supply has gone up. The price has got to go down for a little borrowing overnight. And what is the price of borrowing? Well, that's interest rates. So now for this transaction to occur, all of a sudden maybe this guy needs it less, this guy wants to lend even more because he has more. So now maybe this transaction will occur at an 8% interest rate. And maybe the Fed has a target rate of 5%. They want to see a reality where this bank is lending to that bank at a 5% rate. So what would they do? Well, they would just keep doing this process. They would issue a little bit more. I realize I'm not going to have time. But you see the process. They'd issue some more notes, buy some more treasuries. Those notes would end up in the banking system so the demand for overnight lending will go down and there'll be more of those reserves out there. So the rate at which people lend to each other will go down. Anyway, I'll see you in the next video.