The Fed Funds Rate In Depth

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The Fed Funds RateIn Depth

• Zachary Emig
• MBA Class of 2005
• Ross School of Business Finance Club

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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 its important to not only memorize
the important numbers, but have an understanding
of what they mean, how they were decided, who
decides them, etc.
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The Federal Reserve

• The Federal Reserve is Americas 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/frseri
2.htm
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Fed Goal and Tools

• By the Federal Reserve Act, the Feds 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/faqm
po.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, youd 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 its 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/reser
vereq.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/faqm
po.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 ltINDEXgt HP ltGogt
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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 doesnt want to be in the
  business of lending money, except as a last
  resort.

http//www.federalreserve.gov/monetarypolicy/disco
untrate.htm http//www.frbdiscountwindow.org/faqs.
cfm?hdrID14dtlID756
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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 ltCMDTYgt HP ltGogt
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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 wasnt 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 ltCmodtygt DES ltGogt 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. Thats 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 Decembers 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 ltCMDTYgt HP ltGogt
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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 months 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 doesnt.
So2.115 (13/31)(2.00) (18/31)(2.25P
2.00(1-P))
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Doing the Math
2.115 (13/31)(2.00) (18/31)(2.25P
2.00(1-P))
2.115 0.84 0.58(0.25P 2.00)
1.28 0.15P 1.16
0.12 0.15P
P 80
Thus, on Nov. 11th, the market thinks theres 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. 5ths 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