Nick I, Herbert A, Zachary C
Financial Markets and Institutions
Central Bank Case
The federal funds rate is the term coined to describe the interest rate at which depository institutions lend and borrow overnight funds, which are maintained at the Federal Reserve, to one another. The official website of the Fed states that “By trading government securities, the New York Fed affects the federal funds rate, which is the interest rate at which depository institutions lend balances to each other overnight.” Essentially, institutions that possess surplus end-of-day balances lend the excess funds to institutions that are facing shortfalls in their respective account balances. The federal funds rate has an important influence on the market due to its impact on monetary and financial conditions; thus, it has a significant bearing on macroeconomic factors i.e., employment, inflation and growth. The FOMC is the governmental organization that monitors the federal funds rate and manipulates it by conducting open market operations. Open market operations (OMO) are activities by the Federal Reserve in the buying and selling of government securities on the open market. Through the execution of OMO’s, the Federal Reserve primarily aims to influence the short-term interest rates in the economy. Hence, the federal funds rate is a mechanism that allows the FOMC to regulate the supply of available funds and thus other interest rates and the level of inflation in the economy. In simplistic terms, if the FOMC seeks to increase the federal funds rate, they will take the action of selling securities on the open market thus effectively taking out money from the economy and reducing the supply of money. Citrus paribus, the interest- rates, which are basically the cost of borrowing money, rise. Inversely, if the FOMC seeks to reduce the federal funds rate, they will implement a repurchase agreement (the sale of a government security with an agreement for the seller to purchase the bond at a later date), which essentially is an injection of additional money supply into the economy. Citrus paribus, this has the effect of reducing interest-rate levels. The Federal Reserve is unable to establish a specific federal funds discount rate, but it does set a federal funds target rate at the FOMC meetings. The Committee sets this target rate at a level that it deems will be aligned to its responsibility of attaining monetary policy objectives and amends it depending on financial and economic developments. While many of the crisis-related programs have expired or been closed, the Federal Reserve continues to take actions to fulfill its statutory objectives for monetary policy: maximum employment and price stability. Over recent years, many of these actions have involved substantial purchases of longer-term securities aimed at putting downward pressure on longer-term interest rates and easing overall financial conditions. These charts below plots the federal funds rate and the rate after adjusting for the annual change in the price index for personal consumption expenditures excluding food and energy prices.
The Federal Reserve responded aggressively to the financial crisis that emerged in the summer of 2007. The reduction in the target federal funds rate from 5-1/4 percent to effectively zero was an extraordinarily rapid easing in the stance of monetary policy. In addition, the Federal Reserve implemented a number of programs designed to support the liquidity of financial institutions and foster improved conditions in financial markets. These programs led to significant changes to the Federal Reserve's balance sheet. On December 16, 2008. After an FOMC meeting, the federal funds rate saw a 75 to 100 basis point cut from 1.0% to a scope of 0% to 0.25%. Where it has remained in that zone for the past 6 years.
The FOMC, in setting monetary policy, aims to minimize the deviations of...
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