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 what you know what when I read the the newspaper headlines about all of this I don't hear about the open market transaction 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 and what do these words mean and how do these relate to open market transactions so that's what we'll we'll try to go over right now so what we're going to focus on is the target rate and in the probably in the next video or in a couple of more videos we'll focus more on the discount rate and there are two different things although they're often used in conjunction with each other and they're they're kind of 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 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 do it a little bit different than I normally do this 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 every video so far I've been drawing the reserves on the bottom of the of the assets and that actually made it a little confusing when you compare the reserves to the to the demand deposits I'm assuming all of the liabilities or 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 their in their vault or it could be demand 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 so and just so you understand this this asset is a liability of the Federal Reserve maybe you know it's roughly that much of it so that's that an asset for the bank liability for the froze over and this reserved for this Bank is a liability of 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 and this would just say you know 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 it looks nice when I color in the squares this Bank its reserves just the way I've drawn it are clearly it's reserve issues 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 of now that 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 gonna say 10% well this one looks more like it has I don't know closer to 20% reserves and I remember banks you know we talked about regulation 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 would always want to keep some reserves but you don't want to keep too much reserves because what happens to 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're if you are curious how the [ __ ] how the Fed actually supports itself well it gives these banks reserve accounts which were 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 sheet so it pays no interest on its liabilities let me and it's liabilities are these things right here 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 I this brown color will assume that these are Treasuries right so if I have a government Treasury it probably gives me some interest so I'm paying no interest from the Fed I'm paying no interest on this on these deposits or on these notes outstanding and I get interest on my assets so that's that's easy money and it actually turns out that what the Fed does and this kind of well this is why it's very ambiguous whether it's really independent of the government or not and you know it is officially a private institution but it's Board of Directors it's appointed by the government and 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 you know 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 would become insolvent Congress is obligated we learned before that these these Treasury notes are obligations of the US 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 a part of a part of the government but with that said well actually I should say part of the Treasury not so much part of Congress I'm I'm 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 cuz you don't get any interest on it let's say that this guy he'll he wants 15% reserves that he figures that that's 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 this much reserves right reserves would actually be physical cash or reserve deposits with the Fed and this guy he has let me see let me draw in another car he has about this much to lend right he has roughly about this much right here to lend and so the obvious thing says 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 gonna want their money back etc so we're just lending overnight and if this guy still feels comfortable situation he can he can continue that lending he could 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 the guy for lending this little chunk of money let me Circle it again for lending this chunk of money let me do it in another shade of green for lending this chunk of money overnight to this to this Bank let's just say right now this Bank says all I'll charge you I don't know I'll charge you ten percent overnight I'll charge you ten percent to lend this money to you overnight so it's not it's not like you're paying ten percent just for one night loan it's an annual rate of ten percent so overnight you're paying some you know this to the one 365th power or however many business days 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 you know overnight and overnight for a whole year what that said let's say that the Fed decides that 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 what was that mechanism so what the Fed does is it can print it can print notes and so either notes or let's just say it's actually a physical cash so there you go it prints some notes that's an asset that the Fed is holding now and of course it has an offset 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 so what it does is it and it buys into the open market advise you know maybe that 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 and they buy Treasuries with it so then that asset then turns to Treasuries on 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 does 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 let's say some of the grandmothers put the money in this Bank all right 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 that's what the open and so what what happened what was the net effect of that the government's balance sheet increased a little bit if you look at this total assets its expanded a little bit or if you actually just look at his total liabilities its balance sheet grew it took on some Treasuries and I will have a whole video on what the impact on Treasury interest rates that does but in the process when it bought those treasures in the open market more cash got deposited into the banking system and these could be key this could be cash or could be reserved with the central bank but now let's think about this this the 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 now you know maybe now this guy went from ten percent maybe now he has a twelve percent reserve ratio because he got some deposits of actual cash and maybe this guy went from 20 percent to I don't know 20 22 percent so now this guy needs less money right his his his 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 I guess even a bigger surplus right so the supply of reserves has increased in the banking system the supply has increased from the lending bank and the demand from the borrowing bank has lowered so now if 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 they they have 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 maybe they would issue a little bit more or I realize I'm out of time but you see the process they dish OU's 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 then the rate at which people lend to each other will go down anyway I'll see you in the next video