The Fed Funds Rate
In Depth
Zachary Emig
MBA Class of 2005
Ross School of Business Finance Club
1
FOMC Meeting
On November 10th, 2004, the FOMC met; what
was the outcome of their meeting?
But before you answer that: what is the FOMC?
Back up further: what is the Fed?
The point: it’s important to not only memorize the
important numbers, but have an understanding of
what they mean, how they were decided, who
decides them, etc.
2
The Federal Reserve
The Federal Reserve is America’s Central Bank,
formed in 1913. It primarily consists of:
• Board of Governors: 7 person board, each serving
[staggered] 14-year terms. Nominated by the
President and confirmed by the Senate.
• Reserve Banks: US is divided into 12 districts,
each served by a Reserve Bank, responsible for
day-to-day monetary policy in each district. Each
bank is run by a president, appointed by the
Federal Reserve Board of Governors.
Point: Very politically independent central bank
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The FOMC
The Federal Open Market Committee
consists of:
• The 7 members of the Board of Governors
• The President of the New York Reserve
Bank
• 4 of the remaining 11 Reserve Bank
presidents, on 1 year rotating basis
These 12 members of the FOMC meet 8
times a year to decide monetary policy for
the nation
http://www.federalreserve.gov/pubs/frseries/frseri2.htm
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Fed Goal and Tools
By the Federal Reserve Act, the Fed’s goal is:
“to promote effectively the goals of maximum
employment, stable prices, and moderate
long-term interest rates”
To achieve this, it can use:
• Open market operations
• Discount window lending
• Changing reserve requirements
http://www.federalreserve.gov/generalinfo/faq/faqmpo.htm
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So, back to November 10th…
On November 10th, 2004, the FOMC met; what
was the outcome of their meeting?
Do you think they set the fed funds rate to 2.00%?
Technically, you’d be wrong. The only rate the Fed
itself can directly set is the Discount Rate.
Speaking of which, did the Fed change that on
November 10th?
The Fed raised its Discount Rate to 3.00% from
2.75%. So why does everyone talk about a Fed
Funds rate?
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So What Is The Fed Funds Rate?
In its meetings, the FOMC can only set a target for
the Fed Funds Rate. On Nov. 10th, the FOMC
increeased it’s target from 1.75% to 2.00%.
What does this mean in plain English?
Back up: by law, all depository institutions (banks)
in the US must maintain certain reserves of funds
at Federal Reserve Banks, set by the Board of
Governors. This is a potent monetary tool, albeit
seldom used. It was last changed in April ’92,
reduced from 12% to 10% (to combat the
recession).
http://www.federalreserve.gov/monetarypolicy/reservereq.htm
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The Fed Funds Rate
Since banks’ holdings changes every day, their
reserve requirements change every day.
If at the end of the day they are short on reserves,
they can borrow those reserves from another
depository institution.
The “federal funds rate is the rate charged by
one depository institution on an overnight sale
of immediately available funds (balances at the
Federal Reserve) to another depository
institution.”
http://www.federalreserve.gov/generalinfo/faq/faqmpo.htm
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The Fed Funds Rate
Thus, the
Fed Funds
Rate is a
market
rate
between
depositor
banks, and
only
indirectly
“set” by
the Fed.
Bloomberg: FEDL01 <INDEX> HP <Go>
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The Discount Rate
In comparison, the discount rate is the
interest rate depository institutions will be
charged by the Fed to borrow [overnight]
needed reserves.
Note that it is higher than the Fed Funds
rate, because the Fed doesn’t want to be
in the business of lending money, except
as a last resort.
http://www.federalreserve.gov/monetarypolicy/discountrate.htm
http://www.frbdiscountwindow.org/faqs.cfm?hdrID=14&dtlID=75#6
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Why Does This Matter?
How do these interest rates relate to the real
world?
Think about it. Higher short term interest rates
mean it costs more to borrow money, affecting the
economy through:
Curbing consumer spending through higher credit
card rates.
Slowing business investment due to higher
borrowing costs.
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Market Expectations for Fed Funds
It sure would be nice if we could predict FOMC
decisions, or at least know what the market was
expecting. How can we do that?
Thankfully, on the Chicago Board of Trade there is
a Fed Funds Futures contract that is very actively
traded, and from which we can back out the
market expectations for rate hikes.
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Fed Funds Futures as of Nov. 11
Bloomberg: FFX4 <CMDTY> HP <Go>
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What Does This Mean?
Why was the Fed Funds Futures rate on both Nov.
9th and 10th the same, 1.925?
Why wasn’t the Fed Funds Futures rate 2.00 on
November 10th, after the FOMC decision?
As always, when unsure about prices/rates/values,
make sure you understand what is being sold.
FFX4 <Cmodty> DES <Go>: “The Fed Fund futures
contract is cash settled to the simple average overnight Fed
Funds Rate (the effective rate) for the delivery month. The
overnight rate is calculated and reported daily by the
Federal Reserve Bank of New York.”
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November Makes Sense
Thus, it makes sense that the pre- and post-FOMC
decision rates are the same; this just means the
market completely expected the Nov. 10 25bp
hike.
It also makes sense that the
Futures rate would still be below
2.00. That’s because the November
Futures contract will pay out the
average of the daily fed funds rates
over the entire month, including the
first 9 days where the rate was
below 2.00!
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Predicting December’s FOMC
The FOMC next meets on December 14th; what do
the December Fed Funds Futures prices tell us about
market expectations (as of Nov. 11) for that
meeting?
This is the only number you need
to figure out market expected
probability for a Dec. 14 rate hike!
Bloomberg: FFZ4 <CMDTY> HP <Go>
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Doing the Math
The December Fed Funds Futures contract will pay
out the average of the daily effective Fed Funds
rates over the month’s 31 days.
We know that for the first 13 days, the funds rate
it should roughly be 2.00%.
Choose variable P to be the probability the Fed
raises another 25bp; 1-P is the chance it doesn’t.
So:
2.115% = (13/31)*(2.00%) + (18/31)*(2.25%*P
+ 2.00%*(1-P))
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Doing the Math
2.115% = 0.84%
(13/31)*(2.00%)
+ 0.58*(0.25%*P
+ (18/31)*(2.25%*P
+ 2.00%)
+ 2.00%*(1-P))
1.28% = 0.15%*P + 1.16%
0.12% = 0.15%*P
P = 80%
Thus, on Nov. 11th, the market thinks there’s an
80% chance of another 25bp hike in December!
Interestingly, a week earlier (Nov. 4) the contract
was priced at 2.070, corresponding to a 48%
chance of hike. Why the difference?
Nov. 5th’s payroll blowout of +337,000.
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Assumptions
Always keep in mind the assumptions which
went into this calculation:
• That the Fed can choose only between
maintaining rates and raising 25bp
• That the Fed can only act on its meeting
dates (it can raise/lower rates any time it
wants)
In this case, both of these assumptions are
fairly reasonable.
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Summary
You should now have a better
understanding of:
• How the Fed is organized
• What the Fed Funds Rate and Discount
Rates are, and how they are set
• How to determine market expectations for
future FOMC rate movements
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