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The Fed Funds RateThe Fed Funds RateIn DepthIn Depth

Zachary EmigZachary Emig

MBA Class of 2005MBA Class of 2005

Ross School of Business Finance ClubRoss School of Business Finance Club

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FOMC MeetingFOMC Meeting

But before you answer that: what is the But before you answer that: what is the FOMC?FOMC?

On November 10On November 10thth, 2004, the FOMC met; , 2004, the FOMC met; what was the outcome of their meeting?what was the outcome of their meeting?

Back up further: what is the Fed?Back up further: what is the Fed?

The point: it’s important to not only The point: it’s important to not only memorize the important numbers, but have memorize the important numbers, but have an understanding of what they mean, how an understanding of what they mean, how they were decided, who decides them, etc.they were decided, who decides them, etc.

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The Federal ReserveThe Federal ReserveThe Federal Reserve is America’s Central Bank, The Federal Reserve is America’s Central Bank,

formed in 1913. It primarily consists of:formed in 1913. It primarily consists of:

• Board of Governors: 7 person board, each Board of Governors: 7 person board, each serving [staggered] 14-year terms. Nominated serving [staggered] 14-year terms. Nominated by the President and confirmed by the Senate.by the President and confirmed by the Senate.

• Reserve Banks: US is divided into 12 districts, Reserve Banks: US is divided into 12 districts, each served by a Reserve Bank, responsible for each served by a Reserve Bank, responsible for day-to-day monetary policy in each district. day-to-day monetary policy in each district. Each bank is run by a president, appointed by Each bank is run by a president, appointed by the Federal Reserve Board of Governors.the Federal Reserve Board of Governors.

Point: Very politically independent central Point: Very politically independent central bankbank

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The FOMCThe FOMCThe Federal Open Market Committee The Federal Open Market Committee

consists of:consists of:• The 7 members of the Board of The 7 members of the Board of

GovernorsGovernors• The President of the New York The President of the New York

Reserve BankReserve Bank• 4 of the remaining 11 Reserve Bank 4 of the remaining 11 Reserve Bank

presidents, on 1 year rotating basispresidents, on 1 year rotating basisThese 12 members of the FOMC meet These 12 members of the FOMC meet

8 times a year to decide monetary 8 times a year to decide monetary policy for the nationpolicy for the nationhttp://www.federalreserve.gov/pubs/frseries/frseri2.htmhttp://www.federalreserve.gov/pubs/frseries/frseri2.htm

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Fed Goal and ToolsFed Goal and ToolsBy the Federal Reserve Act, the Fed’s By the Federal Reserve Act, the Fed’s

goal is:goal is:

““to promote effectively the goals of to promote effectively the goals of maximum employment, stable prices, maximum employment, stable prices, and moderate long-term interest rates”and moderate long-term interest rates”

To achieve this, it can use:To achieve this, it can use:

• Open market operationsOpen market operations

• Discount window lendingDiscount window lending

• Changing reserve requirementsChanging reserve requirements

http://www.federalreserve.gov/generalinfo/faq/faqmpo.htmhttp://www.federalreserve.gov/generalinfo/faq/faqmpo.htm

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So, back to November 10So, back to November 10thth……On November 10On November 10thth, 2004, the FOMC met; , 2004, the FOMC met; what was the outcome of their meeting?what was the outcome of their meeting?

Do you think they set the fed funds rate to Do you think they set the fed funds rate to 2.00%?2.00%?Technically, you’d be wrong. The only rate Technically, you’d be wrong. The only rate the Fed itself can directly set is the Discount the Fed itself can directly set is the Discount Rate. Speaking of which, did the Fed Rate. Speaking of which, did the Fed change that on November 10change that on November 10thth??

The Fed raised its Discount Rate to 3.00% The Fed raised its Discount Rate to 3.00% from 2.75%. So why does everyone talk from 2.75%. So why does everyone talk about a Fed Funds rate?about a Fed Funds rate?

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So What Is The Fed Funds So What Is The Fed Funds Rate?Rate?In its meetings, the FOMC can only set a In its meetings, the FOMC can only set a targettarget for the Fed Funds Rate. On Nov. 10 for the Fed Funds Rate. On Nov. 10thth, , the FOMC increeased it’s target from 1.75% the FOMC increeased it’s target from 1.75% to 2.00%.to 2.00%.What does this mean in plain English?What does this mean in plain English?

Back up: by law, all depository institutions Back up: by law, all depository institutions (banks) in the US must maintain certain (banks) in the US must maintain certain reserves of funds at Federal Reserve Banks, reserves of funds at Federal Reserve Banks, set by the Board of Governors. This is a set by the Board of Governors. This is a potent monetary tool, albeit seldom used. It potent monetary tool, albeit seldom used. It was last changed in April ’92, reduced from was last changed in April ’92, reduced from 12% to 10% (to combat the recession).12% to 10% (to combat the recession).

http://www.federalreserve.gov/monetarypolicy/reservereq.htmhttp://www.federalreserve.gov/monetarypolicy/reservereq.htm

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The Fed Funds RateThe Fed Funds RateSince banks’ holdings changes every day, Since banks’ holdings changes every day,

their reserve requirements change every their reserve requirements change every day.day.

If at the end of the day they are short on If at the end of the day they are short on reserves, they can borrow those reserves reserves, they can borrow those reserves from another depository institution.from another depository institution.

The “The “federal funds ratefederal funds rate is the rate is the rate charged by one depository institution on charged by one depository institution on an overnight sale of immediately available an overnight sale of immediately available funds (balances at the Federal Reserve) to funds (balances at the Federal Reserve) to another depository institution.”another depository institution.”

http://www.federalreserve.gov/generalinfo/faq/faqmpo.htmhttp://www.federalreserve.gov/generalinfo/faq/faqmpo.htm

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The Fed Funds RateThe Fed Funds RateThus, the Thus, the Fed Fed Funds Funds Rate is a Rate is a market market rate rate between between depositor depositor banks, banks, and only and only indirectly indirectly “set” by “set” by the Fed.the Fed.

Bloomberg: FEDL01 <INDEX> HP Bloomberg: FEDL01 <INDEX> HP <Go><Go>

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The Discount RateThe Discount RateIn comparison, the In comparison, the discount ratediscount rate is the is the

interest rate depository institutions will interest rate depository institutions will be charged be charged by the Fedby the Fed to borrow to borrow [overnight] needed reserves.[overnight] needed reserves.

Note that it is higher than the Fed Funds Note that it is higher than the Fed Funds rate, because the Fed doesn’t want to rate, because the Fed doesn’t want to be in the business of lending money, be in the business of lending money, except as a last resort.except as a last resort.

http://www.federalreserve.gov/monetarypolicy/discountrate.htm

http://www.frbdiscountwindow.org/faqs.cfm?http://www.frbdiscountwindow.org/faqs.cfm?hdrID=14&dtlID=75#6hdrID=14&dtlID=75#6

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Why Does This Matter?Why Does This Matter?How do these interest rates relate to the real How do these interest rates relate to the real world?world?

Think about it. Higher short term interest Think about it. Higher short term interest rates mean it costs more to borrow money, rates mean it costs more to borrow money, affecting the economy through:affecting the economy through:

Curbing consumer spending through higher Curbing consumer spending through higher credit card rates.credit card rates.

Slowing business investment due to higher Slowing business investment due to higher borrowing costs.borrowing costs.

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Market Expectations for Fed Market Expectations for Fed FundsFundsIt sure would be nice if we could predict It sure would be nice if we could predict FOMC decisions, or at least know what the FOMC decisions, or at least know what the market was expecting. How can we do that?market was expecting. How can we do that?

Thankfully, on the Chicago Board of Trade Thankfully, on the Chicago Board of Trade there is a Fed Funds Futures contract that is there is a Fed Funds Futures contract that is very actively traded, and from which we can very actively traded, and from which we can back out the market expectations for rate back out the market expectations for rate hikes.hikes.

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Fed Funds Futures as of Fed Funds Futures as of Nov. 11Nov. 11

Bloomberg: FFX4 <CMDTY> HP <Go>Bloomberg: FFX4 <CMDTY> HP <Go>

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What Does This Mean?What Does This Mean?

Why was the Fed Funds Futures rate on both Why was the Fed Funds Futures rate on both Nov. 9Nov. 9thth and 10 and 10thth the same, 1.925? the same, 1.925?

Why wasn’t the Fed Funds Futures rate 2.00 Why wasn’t the Fed Funds Futures rate 2.00 on November 10on November 10thth, , afterafter the FOMC decision? the FOMC decision?

As always, when unsure about As always, when unsure about prices/rates/values, make sure you prices/rates/values, make sure you understand what is being sold.understand what is being sold.FFX4 <Cmodty> DES <Go>: FFX4 <Cmodty> DES <Go>: “The Fed Fund “The Fed Fund futures contract is cash settled to the simple futures contract is cash settled to the simple average overnight Fed Funds Rate (the effective average overnight Fed Funds Rate (the effective rate) for the delivery month. The overnight rate is rate) for the delivery month. The overnight rate is calculated and reported daily by the Federal calculated and reported daily by the Federal Reserve Bank of New York.”Reserve Bank of New York.”

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November Makes SenseNovember Makes SenseThus, it makes sense that the pre- and post-Thus, it makes sense that the pre- and post-FOMC decision rates are the same; this just FOMC decision rates are the same; this just means the market completely expected the means the market completely expected the Nov. 10 25bp hike.Nov. 10 25bp hike.

It also makes sense that the It also makes sense that the Futures rate would still be Futures rate would still be below 2.00. That’s because the below 2.00. That’s because the November Futures contract will November Futures contract will pay out the average of the pay out the average of the daily fed funds rates over the daily fed funds rates over the entire month, including the first entire month, including the first 9 days where the rate was 9 days where the rate was below 2.00!below 2.00!

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Predicting December’s Predicting December’s FOMCFOMC

The FOMC next meets on December 14The FOMC next meets on December 14thth; what ; what do the December Fed Funds Futures prices tell do the December Fed Funds Futures prices tell us about market expectations (as of Nov. 11) us about market expectations (as of Nov. 11) for that meeting?for that meeting?

Bloomberg: FFZ4 <CMDTY> HP <Go>Bloomberg: FFZ4 <CMDTY> HP <Go>

This is the only number you This is the only number you need to figure out market need to figure out market expected probability for a expected probability for a

Dec. 14 rate hike!Dec. 14 rate hike!

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Doing the MathDoing the Math

We know that for the first 13 days, the funds We know that for the first 13 days, the funds rate it should roughly be 2.00%.rate it should roughly be 2.00%.

The December Fed Funds Futures contract The December Fed Funds Futures contract will pay out the average of the daily will pay out the average of the daily effective Fed Funds rates over the month’s effective Fed Funds rates over the month’s 31 days.31 days.

Choose variable P to be the probability the Choose variable P to be the probability the Fed raises another 25bp; 1-P is the chance it Fed raises another 25bp; 1-P is the chance it doesn’t.doesn’t.So:So:2.115% = (13/31)*(2.00%) + 2.115% = (13/31)*(2.00%) + (18/31)*(2.25%*P + 2.00%*(1-P))(18/31)*(2.25%*P + 2.00%*(1-P))

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Doing the MathDoing the Math2.115% = (13/31)*(2.00%) + 2.115% = (13/31)*(2.00%) + (18/31)*(2.25%*P + 2.00%*(1-P))(18/31)*(2.25%*P + 2.00%*(1-P))2.115% = 0.84% + 0.58*(0.25%*P + 2.00%)2.115% = 0.84% + 0.58*(0.25%*P + 2.00%)

1.28% = 0.15%*P + 1.16%1.28% = 0.15%*P + 1.16%

0.12% = 0.15%*P0.12% = 0.15%*P

P = 80%P = 80%

Thus, on Nov. 11Thus, on Nov. 11thth, the market thinks there’s , the market thinks there’s an an 80%80% chance of another 25bp hike in chance of another 25bp hike in December!December!Interestingly, a week earlier (Nov. 4) the Interestingly, a week earlier (Nov. 4) the contract was priced at 2.070, corresponding contract was priced at 2.070, corresponding to a to a 48%48% chance of hike. Why the chance of hike. Why the difference?difference?Nov. 5Nov. 5thth’s payroll blowout of +337,000.’s payroll blowout of +337,000.

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AssumptionsAssumptions

Always keep in mind the assumptions Always keep in mind the assumptions which went into this calculation:which went into this calculation:

• That the Fed can choose only That the Fed can choose only between maintaining rates and between maintaining rates and raising 25bpraising 25bp

• That the Fed can only act on its That the Fed can only act on its meeting dates (it can raise/lower meeting dates (it can raise/lower rates any time it wants)rates any time it wants)

In this case, both of these assumptions In this case, both of these assumptions are fairly reasonable.are fairly reasonable.

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SummarySummary

You should now have a better You should now have a better understanding of:understanding of:

• How the Fed is organizedHow the Fed is organized

• What the Fed Funds Rate and Discount What the Fed Funds Rate and Discount Rates are, and how they are setRates are, and how they are set

• How to determine market expectations How to determine market expectations for future FOMC rate movementsfor future FOMC rate movements