1. 1 The Fed Funds Rate In Depth Zachary Emig MBA Class of 2005 Ross School of Business Finance Club

2. 2 FOMC Meeting But before you answer that: what is the FOMC? On November 10 th, 2004, the FOMC met; what was the outcome of their meeting? Back up further: what is the Fed? The point: it’s important to not only memorize the important numbers, but have an understanding of what they mean, how they were decided, who decides them, etc.

3. 3 The Federal Reserve The Federal Reserve is America’s Central Bank, formed in 1913. It primarily consists of: Board of Governors: 7 person board, each serving [staggered] 14-year terms. Nominated by the President and confirmed by the Senate. Board of Governors: 7 person board, each serving [staggered] 14-year terms. Nominated by the President and confirmed by the Senate. Reserve Banks: US is divided into 12 districts, each served by a Reserve Bank, responsible for day-to-day monetary policy in each district. Each bank is run by a president, appointed by the Federal Reserve Board of Governors. Reserve Banks: US is divided into 12 districts, each served by a Reserve Bank, responsible for day-to-day monetary policy in each district. Each bank is run by a president, appointed by the Federal Reserve Board of Governors. Point: Very politically independent central bank

4. 4 The FOMC The Federal Open Market Committee consists of: The 7 members of the Board of Governors The 7 members of the Board of Governors The President of the New York Reserve Bank The President of the New York Reserve Bank 4 of the remaining 11 Reserve Bank presidents, on 1 year rotating basis 4 of the remaining 11 Reserve Bank presidents, on 1 year rotating basis These 12 members of the FOMC meet 8 times a year to decide monetary policy for the nation http://www.federalreserve.gov/pubs/frseries/frseri2.htm

5. 5 Fed Goal and Tools By the Federal Reserve Act, the Fed’s goal is: “to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates” To achieve this, it can use: Open market operations Open market operations Discount window lending Discount window lending Changing reserve requirements Changing reserve requirements http://www.federalreserve.gov/generalinfo/faq/faqmpo.htm

6. 6 So, back to November 10 th … On November 10 th, 2004, the FOMC met; what was the outcome of their meeting? Do you think they set the fed funds rate to 2.00%? Technically, you’d be wrong. The only rate the Fed itself can directly set is the Discount Rate. Speaking of which, did the Fed change that on November 10 th ? The Fed raised its Discount Rate to 3.00% from 2.75%. So why does everyone talk about a Fed Funds rate?

7. 7 So What Is The Fed Funds Rate? In its meetings, the FOMC can only set a target for the Fed Funds Rate. On Nov. 10 th, the FOMC increeased it’s target from 1.75% to 2.00%. What does this mean in plain English? Back up: by law, all depository institutions (banks) in the US must maintain certain reserves of funds at Federal Reserve Banks, set by the Board of Governors. This is a potent monetary tool, albeit seldom used. It was last changed in April ’92, reduced from 12% to 10% (to combat the recession). http://www.federalreserve.gov/monetarypolicy/reservereq.htm

8. 8 The Fed Funds Rate Since banks’ holdings changes every day, their reserve requirements change every day. If at the end of the day they are short on reserves, they can borrow those reserves from another depository institution. The “federal funds rate is the rate charged by one depository institution on an overnight sale of immediately available funds (balances at the Federal Reserve) to another depository institution.” http://www.federalreserve.gov/generalinfo/faq/faqmpo.htm

9. 9 The Fed Funds Rate Thus, the Fed Funds Rate is a market rate between depositor banks, and only indirectly “set” by the Fed. Bloomberg: FEDL01 HP Bloomberg: FEDL01 HP

10. 10 The Discount Rate In comparison, the discount rate is the interest rate depository institutions will be charged by the Fed to borrow [overnight] needed reserves. Note that it is higher than the Fed Funds rate, because the Fed doesn’t want to be in the business of lending money, except as a last resort. http://www.federalreserve.gov/monetarypolicy/discountrate.htm http://www.frbdiscountwindow.org/faqs.cfm?hdrID=14&dtlID=75#6

11. 11 Why Does This Matter? How do these interest rates relate to the real world? Think about it. Higher short term interest rates mean it costs more to borrow money, affecting the economy through: Curbing consumer spending through higher credit card rates. Slowing business investment due to higher borrowing costs.

12. 12 Market Expectations for Fed Funds It sure would be nice if we could predict FOMC decisions, or at least know what the market was expecting. How can we do that? Thankfully, on the Chicago Board of Trade there is a Fed Funds Futures contract that is very actively traded, and from which we can back out the market expectations for rate hikes.

13. 13 Fed Funds Futures as of Nov. 11 Bloomberg: FFX4 HP Bloomberg: FFX4 HP

14. 14 What Does This Mean? Why was the Fed Funds Futures rate on both Nov. 9 th and 10 th the same, 1.925? Why wasn’t the Fed Funds Futures rate 2.00 on November 10 th, after the FOMC decision? As always, when unsure about prices/rates/values, make sure you understand what is being sold. FFX4 DES : “The Fed Fund futures contract is cash settled to the simple average overnight Fed Funds Rate (the effective rate) for the delivery month. The overnight rate is calculated and reported daily by the Federal Reserve Bank of New York.”

15. 15 November Makes Sense Thus, it makes sense that the pre- and post-FOMC decision rates are the same; this just means the market completely expected the Nov. 10 25bp hike. It also makes sense that the Futures rate would still be below 2.00. That’s because the November Futures contract will pay out the average of the daily fed funds rates over the entire month, including the first 9 days where the rate was below 2.00!

16. 16 Predicting December’s FOMC The FOMC next meets on December 14 th ; what do the December Fed Funds Futures prices tell us about market expectations (as of Nov. 11) for that meeting? Bloomberg: FFZ4 HP Bloomberg: FFZ4 HP This is the only number you need to figure out market expected probability for a Dec. 14 rate hike!

17. 17 Doing the Math We know that for the first 13 days, the funds rate it should roughly be 2.00%. The December Fed Funds Futures contract will pay out the average of the daily effective Fed Funds rates over the month’s 31 days. Choose variable P to be the probability the Fed raises another 25bp; 1-P is the chance it doesn’t. So: 2.115% = (13/31)*(2.00%) + (18/31)*(2.25%*P + 2.00%*(1-P))

18. 18 Doing the Math 2.115% = (13/31)*(2.00%) + (18/31)*(2.25%*P + 2.00%*(1-P)) 2.115% = 0.84% + 0.58*(0.25%*P + 2.00%) 1.28% = 0.15%*P + 1.16% 0.12% = 0.15%*P P = 80% Thus, on Nov. 11 th, the market thinks there’s an 80% chance of another 25bp hike in December! Interestingly, a week earlier (Nov. 4) the contract was priced at 2.070, corresponding to a 48% chance of hike. Why the difference? Nov. 5 th ’s payroll blowout of +337,000.

19. 19 Assumptions Always keep in mind the assumptions which went into this calculation: That the Fed can choose only between maintaining rates and raising 25bp That the Fed can choose only between maintaining rates and raising 25bp That the Fed can only act on its meeting dates (it can raise/lower rates any time it wants) That the Fed can only act on its meeting dates (it can raise/lower rates any time it wants) In this case, both of these assumptions are fairly reasonable.

20. 20 Summary You should now have a better understanding of: How the Fed is organized How the Fed is organized What the Fed Funds Rate and Discount Rates are, and how they are set What the Fed Funds Rate and Discount Rates are, and how they are set How to determine market expectations for future FOMC rate movements How to determine market expectations for future FOMC rate movements