Last year, when the Federal Reserve realized that the inflation, which was earlier thought to be “transitory,” might be feeding on itself and soon spiral out of control, it acted swiftly to respond with an aggressive interest rate hike cycle, one of the quickest on record.
As a result, we have gone from living in a world of virtually free money, marked by a target federal funds rate of 0% to 0.25%, for more than 12 years since the global financial crisis to a world of constricted credit, with a target rate at 4.50% to 4.75%, the highest since 2007.
Right on cue, the market and economy responded to the end of the era of easy money with withdrawal tantrums. Although the Fed has been able to bring down CPI inflation from a 40-year high of 9.1% in June 2022 to 6.4% in January 2023, it has come at the cost of increased market volatility, stressed margins due to increased borrowing costs, and bank runs due to bond price devaluations.
Given that the federal funds rate appears to be nothing short of a force of nature for the capital markets and the economy at large, its deeper understanding would serve market participants well.
What is the Federal Funds Rate?
The federal funds rate is the interest rate that banks charge other institutions for lending excess cash to them from their reserve balances on an overnight basis.
Legally, all banks are required to maintain a percentage of their deposits as a reserve in an account at a Federal Reserve bank. This mandated amount is known as the reserve requirement, and compliance of a bank is determined by averaging its end-of-the-day balances over two-week reserve maintenance periods.
Banks, which expect to have end-of-the-day balances greater than the reserve requirement, can lend the surplus to institutions that expect to have a shortfall.
The Federal Open Market Committee (FOMC) guides this overnight lending of excess cash among U.S. banks by setting the target interest rate as a range between an upper and lower limit. This target interest rate is called the federal funds rate. Continue reading "What to Do When Interest Rates Rise"