Fed fund rate is a short run interest rate set by US Central Bank to control money supply in the economy. It is the interest rate at which one commercial bank charges other bank over-night, it is also known inter-bank interest rate. Generally, all types of interest rates prevailing in the economy follow the movement of fed fund rate. Fed fund rate is also called fed rate. The term fed rate would be used throughout this article.
US Central Bank is known as Federal Reserve System, in brief FED. The term FED will be used in this writing.
When the economy is over heated, FED targets higher fed rate to control spending in an effort to avoid inflation. On the other hand, when economy is heading to recession, FED targets lower fed rate to spur growth by easing credit. Currently, FED has targeted near zero fed rate to stimulate the ailing economy. Since fed rate is zero, all interest rates, saving rates, lending rates have fallen to record low to follow fed rate. For the first time, fed rate has been near zero percent.
Fed rate is also called key interest rate as most of the interest rates globally and nationally follows it.
How the targeted fed fund rate is achieved?
Suppose, the economy is heading to recession, FED targets lower fed rate, suppose 1 percent. To achieve the target, FED continues to inject money by buying short term bonds. As soon as fed rate hits at 1 percent, FED stop purchasing. On the other hand, when the economy is soaring, money supply should be squeezed to avoid inflation. FED targets higher fed rate, suppose 4 percent To attain the target, FED continues to sale bond to mop up excess liquidity from the banking system. Due to withdrawing money, money supply gets squeezed, that triggers price of money, which is fed rate. As soon as fed rate become 4 percent, FED stops bond selling.
Fed buys private bond as well as government bond (treasury) to achieve its targeted fed rate. Normally FED buys treasury bonds to meet budget deficit of federal government.
It can be explained in other way, when FED starts to sale treasury bonds, supply of bond increases in the market, so price of the bond start to fall. As a result, yield of the bond or interest rate start to hike as there exists an opposite correlation between bond’s price and yield. On the other hand, when FED buys bond from the market, there arises bond shortage that triggers the bond’s price, so yield or interest rate gets down.
US treasury yield or interest rate influences all interest rate prevailing in the USA.
II. LONG TERM INTEREST RATE
Long term interest rate is the yield or interest rate of long term 5 year, 10 year, 30 year treasury bonds, is generally manipulated by quantitative easing (QE) program
What is quantitative easing (QE)?
Quantitative easing is a deliberate action by Central Bank to increase money supply in the economy or easing to get money. Under QE program, Central Bank generally prints large amount of money for injecting into economy by buying different types of bonds or assets. Since Central Bank buys assets, asset side of its balance sheet gets ballooned.
1.It is an unconventional monetary policy adopted by the Central Bank to increase money supply in the economy.
2.It is adopted when conventional monetary policy fails to stimulate economy.
3. QE program generally targets to buy long term 5 year, 10 year, 30 year treasury bonds (government bond) to reduce long term interest rate.
4. Bank of Japan in 2001 and Bank of England and European Central Bank embraced quantitative easing during financial crisis (2007-2010). USA ran it from 2008 to 2011. QE was used by these countries when their inter-bank interest rates are near to zero percent.
5. QE is the last resort to stimulate the economy
When QE is generally adopted?
1. When the fed rate is brought to zero percent but the economy is not growing enough, QE is adopted to increase further money supply.
2. One of the targets of QE program is to tackle deflation. When economy is heading to deflation due to high unemployment and deficient demand, Central Bank may intervene by supplying tons of money so that inflation may not go far below from targeted 2 percent.
How QE is implemented?
As I said, FED purchases short term bond to control short run interest rate such as fed rate. But by reducing short run interest rate, long term investment on housing, car, machinery etc may not be soared. There requires low long term interest rate to go down. Under QE program, FED purchased long term bonds to reduce long term interest rates or yield.
Under QE program, FED printed billions of dollars electronically to buy long term bonds. When bond was bought, price of the bond went up while yield or interest rate went down as there exists an opposite association between bond’s price and its interest rate. So when yield goes down, all types of long term interest rates go down on car, housing mortgage, machinery, factories etc. As a result, long run spending gears up, helps in healing ailing economy.
Why long run interest rate to be down?
Since the fed rate is almost zero percent, bank managers borrow cheap money from other banks but decline to lend to business or households due to risk. As a result, money is not investing into economy. What the managers are doing with this cheap money? They are buying treasury bonds to get higher interest. Treasury is always preferable due to its risk free nature.
In order the tackle the situation, FED is buying mainly long term treasury to reduce yield. As soon as yield gets gown, there is less incentive to buy treasury bonds. Finding no other alternative, bank managers give loan to business and households. So money can enter into economy.
What are the FED’s targets under QE program ?
Few targets FED has set:
1.Pushes down mainly long run interest rate (also keep short run rate at near zero percent) to spur spending
2.To keep stock indices at a desirable level
4.Increasing excess reserve in the banking system to maintain zero fed rate
5.Stop the foreclosure in the housing industry.
7.Supporting banking industry by purchasing toxic mortgage securities
B. DISTINCTIONS BETWEEN CONVENTIONAL POLICY AND QE
1.Conventional monetary policy controls short run inter-bank interest rate while QE controls long run interest rate.
2.Conventional monetary policy targets fed rate to be manipulated while QE is targeting quantity of money to be supplied in the economy, not fed rate.
C. SIMILARITIES BETWEEN CONVENTIONAL POLICY AND QE
1.To increase money supply in the economy. 2.To boost spending of the households, business, government etc.
D. FED EXPERIENCES OF QE PROGRAM
1.Stock prices went down heavily in the late 2008 that impacted adversely US and world economy.
2.So FED intervened the money market in Dec, 2008 by cutting overnight fed rate by 0.75 percent and set it between 0.0 - 0.25 percent (almost zero percent) to raise stock indices and over all spending. Lower fed rate is indeed a credit easing effort.
3.FED implemented zero percent fed rate using discount window (credit by FED to financial institutes) and open market operation (purchasing bond to increase money supply). Fed rate is seen near zero since Dec 2008.
4. Although fed rate was set almost zero (fed rate can not go lower than zero percent), the economy was not growing fast enough, registered at 9 percent unemployment, Fed adopted QE program to pump tons of money in the economy for further stimulation.
5.Quantitative easing in USA had two phases, QE1 and QE2.
6.Under QE1 program, Fed purchased $1.75 trillion private and government treasuries from the market. Specifically, US treasuries, mortgage backed securities (MBS) and agency debt were the items in the purchases. The QE1 program ran from Nov 2008 to March 2010. Reducing long term interest rate, inflating reserve in the banking system and reviving housing sector were the main targets of these purchases. Out of $1.75 trillion, $300 billion was treasury purchase. A study reveals that long term rate reduced by 50 basis points under QE1.
7.Since the economy was still struggling in spite of the QE1 program, the Fed adopted second round of quantitative easing, QE2. Fed planned to purchase $900 billion worth of US long term treasury to reduce long term interest rate. QE2 program started from Nov 2010 and to be continued until June 2011. Long term interest rates reduced by 18 basis points during QE2 program.
E. OUTCOME OF QUANTITATIVE EASING IN USA
Due to huge purchases, asset side of Fed’s balance sheet has been swelled, amounted at $ 2650 billion, never seen before. So, $2.7 trillion has been injected into economy over the period 2008-2011. QE has brought mixed results. Some of them are below:
Negative impacts of QE program
1.Prices of commodities, gases have heightened. Meaning that Inflation is escalating, eroding living standard. Billions of dollars have been injecting without equivalent amount of production. Inflation is likely.
2.Value of dollar is depreciating meaning that US assets will be less lucrative to foreigners. As a result, surplus of capital/financial account will be squeezed, that may create an unfavorable balance of payment for USA.
3. As the dollar is depreciating, the confidence on dollar is sliding. People are prefering gold and silver than dollar to store. So demand for gold and silver is soaring worldwide, hence prices.
4.US credit rating is on the fall meaning that US government has to pay higher interest rates on its treasury bonds. Government cost will be heightened hence deficit and debt.
5. Yield on bond is declining meaning that foreigner especially foreign Central Banks may decline to invest their foreign reserve in US treasury bond. So US govt may face problem to finance its budget deficit.
6. With the sliding dollar value, value of US assets is sliding, ultimately national wealth as a whole.
7. With the sliding dollar value, the real value of foreign reserve held in foreign Central Banks is declining (as their foreign reserve mostly kept in US dollar). They are now keeping gold as foreign reserve together with dollar.
Positive impacts of QE program
1.Rate of unemployment dropped to 8.8 percent in March 2011 but increased again to 9 percent in April, 2011. Some analysts say, unemployment rate would have been 12 percent if there were no QE programs.
2.The risk of deflation has been tackled successfully.
3.Stock prices are on the rise, so households’ wealth. Spending may escalate.
4. Value of dollar is sliding meaning that US exports will be encouraged while imports will decline. As a result, deficit in the current account will be squeezed that mayl bring a healthy balance of payment.
5. Although inflation is registered at 2.7 percent in March 2011, moderately higher than targeted 2 percent. It is still manageable
6.GDP growth rate is positive, registered at 1.8 percent in the first quarter of 2011.