Fed Funds Rate Chris Lamoureux Federal Funds Rate

Banking System Member banks in the Federal Reserve System must keep reserves on account

Inferring Fed Policy from Market Prices In general market prices embody expectations about the

Fed Funds Futures 1. Remember that a futures contract is an agreement to buy/sell

Futures and Hedging Fed Funds A natural use of futures is to hedge price

Futures Example (Cont’d. ) But, by trading in the futures market the bank locks

Fed Policy The current Federal Reserve Operating Policy involves targeting the Fed Funds Rate.

Fed Policy --2 Suppose that the Fed Funds Rate were too low, relative to

Fed Funds Futures Contracts on the average Effective Fed Funds Rate in a month

Inferring Aggregate Beliefs Like any liquid financial security, Fed Funds Futures “prices” aggregate the

Assumptions In the example in the accompanying spreadsheet, the assumptions are that we know

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Banking System Member banks in the Federal Reserve System must keep reserves on account with the Fed. If a bank needs more reserves its first recourse is to borrow reserves from a bank that has excess reserves. The Market for overnight lending/borrowing of these bank reserves is called the Federal (Fed) Funds Market. The rate charged on an overnight loan of reserves is the Federal (Fed) Funds Rate. This is a market interest rate—determined by the demand supply of bank reserves. Federal Funds Rate & Fed Policy 1/21/2022 2

Inferring Fed Policy from Market Prices In general market prices embody expectations about the future. When a security is very narrowly defined, we might be able to extract those expectations directly from market prices. (This is akin to looking at gambling odds to extract winning probabilities. ) In this example, we extract market expectations about Fed policy from Fed Funds Futures prices. Federal Funds Rate & Fed Policy 1/21/2022 3

Fed Funds Futures 1. Remember that a futures contract is an agreement to buy/sell at a future date, for an agreed-upon price. When entered the value of the contract is 0. The underlying asset in this case is a $5 million 30 -day deposit in Fed Funds. The final settlement price is set to: 100 – (100 * avg FF rate in the month). All futures contracts are marked to market daily, so this results in $41. 67 in the account, per 1 basis point. ($5 million * ). Federal Funds Rate & Fed Policy 1/21/2022 4

Futures and Hedging Fed Funds A natural use of futures is to hedge price risk. Consider a bank that anticipates lending $5 million each night in the Fed Funds market in November 2001. The rate is 2. 25% on October 31. The rate implicit in the Fed Funds futures price is 2. 21% (The price is 97. 79). (Since the FFR is floating, you can’t use the futures market to lock in today’s rate—just the expectation today. ) Federal Funds Rate & Fed Policy 1/21/2022 5

Futures Example (Cont’d. ) But, by trading in the futures market the bank locks in a certain rate, which can be useful for planning, etc. In this month, the FED did cut rates to 2%, so the average in the month was 2. 087%. This means the final settlement price on the futures contract is 97. 913. I have a spreadsheet that works through this example. Federal Funds Rate & Fed Policy 1/21/2022 6

Fed Policy The current Federal Reserve Operating Policy involves targeting the Fed Funds Rate. They announce a target rate, and then use open market operations to keep the market rate close to this target. For example, the target may be 1%, but there is upward pressure on the actual Fed Funds Rate—such that it is 1. 07%. The Fed will in this case inject reserves into the banking system—increasing their supply—by buying securities from banks using Repo agreements. Federal Funds Rate & Fed Policy 1/21/2022 7

Fed Policy --2 Suppose that the Fed Funds Rate were too low, relative to the target, e. g. , 0. 96%. In this case, the Fed can soak up reserves from the banking system (reducing their availability), by selling securities to member banks using Reverse Repo agreements. Occasionally, the effective Fed Funds Rate may differ significantly from the target. Examples include the Fed supplying liquidity in anticipation of “Y 2 K” and subsequent to Sept. 11, 2001. Federal Funds Rate & Fed Policy 1/21/2022 8

Fed Funds Futures Contracts on the average Effective Fed Funds Rate in a month are publicly traded on the Chicago Board of Trade (CBOT). Contract information can be found at this website: http: //www. cbot. com/cbot/ir/page/0, 2869, 296, 00. html Federal Funds Rate & Fed Policy 1/21/2022 9

Inferring Aggregate Beliefs Like any liquid financial security, Fed Funds Futures “prices” aggregate the valuation of market participants. As a market observer, we can extract this market wisdom from the observed “prices. ” This is analogous to odds in gambling. Because futures contracts depend in a linear (or proportional) way on the price of the underlying asset, this extraction process is direct, and does not entail wild assumptions. Federal Funds Rate & Fed Policy 1/21/2022 10

Assumptions In the example in the accompanying spreadsheet, the assumptions are that we know the timing of Target Rate changes, and the magnitude of possible changes. Federal Funds Rate & Fed Policy 1/21/2022 11