By: Jason Tabalujan McIntire Investment Institute September 10, 2002 The Federal Funds Rate

Synopsis  Definition  Terms – Fed “easing” and Fed “tightening”  Practical applications  Current rates  Interesting discussions

Definition  The overnight interest rate that banks charge one another when they borrow from each other  Based on a 360 day year for simplicity  The Fed targets the funds rate – they cannot “magically” alter market forces and change rates on the spot  The media publishes the targeted Fed Funds rate, not the actual funds rate brought about by market forces  But the targeted rate is close to the actual rate, as you will see later

Basis Points  Target FF rate change always quoted in basis points  Basis point = one hundredth of a percent  E.g. 25 basis points = a quarter of a percent (0.25%)

So what?  Since the Fed Funds rate is the interest rate that banks charge each other, the lowest interest rate around  As the “base” interest rate, the FF rate will dictate or at least heavily influence the cost of borrowing of businesses and consumers  Why is the FF rate the lowest rate around?

Why lowest rate?  Because banks have to charge interest that is higher than what they are paying at, to make money  Since the FF rate is the rate that banks are charged interest on, banks would not lend (to consumers and businesses) at rates lower than the FF rate

Fed Easing  2 perspectives  Wall Street view – a reduction in target FF rate  “Monetarist” economists – an increase in the money supply

Fed Tightening  Wall Street view – an increase in the target FF rate  Monetarists – a decrease in the money supply  Fed meets 8 times a year at the Fed Open Market Committee (FOMC) to ease, tighten or leave the target FF rate as it is. At the last FOMC meeting on August 13, rates were left unchanged at 1.75%

Why is Tightening/Easing so important?  When the economy is in recession, high interest rates will negatively affect a business  Conversely, when the economy is booming, low interest rates can put banks out of business  So the Fed will have to constantly balance between the two, using economic indicators and good judgment

Practical Applications  When interest rates are low, businesses face a cheaper cost of borrowing, loosening up some cash flows  They may be able to invest in riskier opportunities that may result in higher returns ( risk return)  So when interest rates are low, investors can expect an appreciation in the equity markets some time in future (expected future value of cash flows will be higher).  Why doesn’t MII go long when rates are low?

Practical Applications  The key thing is knowing when cheap borrowing is incorporated into a stock’s price – TIMING  Even if you know when cheap borrowing takes effect on stock prices, you may lose  Because of other factors -- investor sentiment, sensitivity of investor reaction to positive news, management and efficiency of firm, etc.

Fed Watch  Target FF rate, April 2001 – August 2002 Source: BusinessWeek.Com

Interesting Discussions  When the target FF rate is low, the risk of inflation is higher because money is cheaper ($1 now is worth less than $1 in the past)  August’s unemployment rate fell from 5.9% to 5.7%, and national industrial production rose in July. Sign of recovery?

Interesting Discussions  Current target FF rate is 1.75%. If the Fed increases it at the next FOMC meeting two weeks from today (September 24, 2002), is it a positive sign that businesses are more productive and better able to pay interest on their loans?  Would this increase investor expectations and thus be a good time to buy?

Questions?