Wednesday, 20 of June of 2018

Economics. Explained.  

Fed Funds Rate

April 27, 2018

The federal funds rate is the overnight rate that banks charge each other to borrow/lend  reserves.  Some banks have more reserves than they need.  Others (principally large banks) are short of reserves and must borrow from other banks in the system, typically on an overnight basis.  The rate at which this borrowing takes place is known as the fed funds rate.  It is the only rate that the Fed can directly control.  Most other short-term interest rates like Treasury bills, CD’s, commercial paper, etc. are very closely linked to this rate, so when the Fed tightens or eases all other short-term rates move in the same direction by essentially the same amount.

Once the recession began in December 2007 the Fed tried to stimulate the economy and ultimately pushed the funds rate almost to 0%.  It remained at that record low level until December 2015.

In December 2015 the Fed decided it was time to alter its policy and push the funds rate towards a more “neutral” policy stance.  So what might be regarded as a  “neutral” level for the funds rate?  The answer lies in the relationship between the funds rate and the inflation rate.  Whether an interest rate is high or low depends entirely on how it stacks up relative to the rate of inflation.  Think of it this way.  A 10% interest rate most of the time would be regarded as punishingly high.  But in the late 1970’s when the inflation rate was 12%, a 10% rate was actually quite cheap.  An investor could borrow at 10% for a year, buy an asset whose price would rise 12%, then pay back the 10% loan a year later and actually make money on the transaction.  So whether rates are high or low really depends upon their relationship to the rate of inflation.

The difference between the funds rate and the inflation rate is known as the “real” funds rate. Over the past 30 years, the funds rate has averaged 1.0% higher than the inflation rate.  As shown below, sometimes it will be higher than that, other times it will be lower.  But over time the “real” funds rate has averaged 1.0%.  Hence, the Fed would probably regard such a “real” funds rate as relatively “neutral”.  So if the Fed wants an inflation rate of 2%, and believes that its policy is neutral when the funds rate is 1.0% higher than that, then by implication a 3.0% funds rate in today’s world would be roughly “neutral”.

But the funds rate today is not at 3.0%, it is 0.1.6%.  Thus, the Fed has a long ways to go.  The Fed expects to raise the funds rate two more times this year which would boost it to 2.1%.  It expects to tighten four times next year which would raise the funds rate to 3.0%, and then twice more in 2020 which would take it to 3.5%.  If all goes as planned, the funds rate would not hit the neutral rate of 3.0% until the end of next year.

The U.S. economy has never dipped into recession until the Fed has pushed the funds rate higher than the so-called “neutral” rate.   In fact, as shown above, it had to raise the funds rate to 6.5% in 2000 and 5.25% in 2007 before the economy spiraled into recession.  If the funds rate is 3.5% by the end of 2020 there is virtually no chance that such a level would be the catalyst for a recession.

Stephen Slifer

NumberNomics

Charleston, SC


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