What is the federal funds rate? Should the Fed worry about not meeting its mandates under law?

Today’s rates ….

30-Day Federal Funds Futures: 94.69.

Effective Federal Funds Rate: 5.33%.

Interest on Reserve Balances: 5.40%.

Discount Window: 5.50%.

CME FedWatch: 96.8%.

EUR/USD=1.0931.

GBP/USD=1.2594.

USD/JPY=149.6608.

(Foreign exchange rates as of 7:38 pm EDT.)

Today’s definition ...

Federal funds rate-the interest rate at which depository institutions lend reserve balances to other depository institutions overnight. — Board of Governors-Federal Reserve System.

Investopedia, a financial news and education website, offers a definition for bank reserves:

“Bank reserves are the cash minimums that financial institutions must have on hand in order to meet central bank requirements. This is real paper money that must be kept by the bank in a vault on-site or held in its account at the central bank. Cash reserves requirements are intended to ensure that every bank can meet any large and unexpected demand for withdrawals.

In the U.S., the Federal Reserve dictates the amount of cash, called the reserve ratio, that each bank must maintain.” 

Today’s takeaway …

Up until 2010, manipulation of the federal funds rate was the primary tool used by the Board of Governors of the Federal Reserve System in order to meet its statutory requirements to bring about maximum employment and stable prices. Specifically, 12 U.S.C. 225a requires the following:

“The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”

Manipulation of the rate is done primarily through open market operations. Open market operations involve the purchase and sale of Treasurys and other securities by the Federal Reserve System for the purpose of affecting the money supply. When the Federal Reserve System purchases bonds from the banking system, it puts cash into the banking system where these funds are (in theory) packaged into loans and sold to businesses and individuals. This pump priming is done to boost the economy.

The sale of bonds and other securities by the Federal Reserve into the banking system has the opposite effect. Banks buy government IOUs by extracting cash from the system. This newly created shortage of cash in the system drives up borrowing costs i.e., interest rates and leads to a slowing in market transactions.

Government and Federal Reserve data over the last seven quarters appears to show that upward revision of the federal funds rate is correlated with increases in borrowing costs.

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For example, at the end of the second quarter 2022, the effective federal funds rate (a weighted average of the overnight rate assessed by banks for borrowing reserves) was 1.58%. Total reserves held either in commercial bank vaults or Federal Reserve bank vaults totaled $3,228.4 billion. The prime lending rate was 4.75% while yields on two-year Treasurys was 2.92%. Personal consumption expenditures amounted to $17,550 billion.

At the end of the third quarter 2022, the effective federal funds rate climbed to 3.08%. Total reserves decreased to $3,131.4 billion. The prime lending rate also increased to 6.25% while yields on two-year Treasurys jumped to 4.22%. Personal consumption continued its climb to $17,804.0 billion.

Fast forward to end of the third quarter 2023 and rates continued to move with the increases in the Fed’s overnight rate (federal funds). The effective federal funds rate increased to its current rate of 5.33% while reserves increased to $3,239.4 billion. Yield on the two-year Treasury was at 5.03% while the prime lending rate climbed to its new high of 8.50%. The increase in interest rates, however, appears not to have crimped the consumer’s spending style. Personal consumption expenditures climbed to $18,853.4 billion.

The Federal Reserve has been signaling that rates will be higher for longer. Media commenters expect that higher for longer will end between next March and the end of 2024. No one knows for sure. But based on the personal consumption numbers, it would appear that the Federal Reserve still has work to do to meet its mandate under 12 U.S.C. 225a.

Here in Atlanta, I have not seen much of a slowdown yet in spending. The energy, however, feels a little subdued and I still hear the “pain and suffering” comments in the grocery aisle as some consumers opine on the continued increases in food prices. This may also be part of the reason why personal consumption expenditures appear to be increasing. We may not be seeing an increase in units purchased, just an increase in prices assessed for certain items.

Independent administrative agencies rarely get haul-keeled for not meeting a statutory mandate. While I doubt that the government or the Congress have ever dragged the Federal Reserve System into court for not meeting its dual mandate, it will be interesting to see if any private citizens have. The dual mandate is a bit of a head fake. Its main purpose is to give the public the appearance that the Federal Reserve operates in the interests of the everyday guy and gal when in reality its role is to maintain the validity of the currency and keep the banking system operating.

Investors want to see returns on capital and the government and the Congress want to see their existence validated by maintaining a demand for the currency. The risk is that as consumer prices continue to increase and yields and probably artificial intelligence reduces the need for the current work force level, will that currency still look valid?

Alton Drew

26 November 2023

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