The federal funds rate: In the end, is it not about supporting the banking system?

The Federal Open Market Committee is set to meet on December 12-13, 2023 to determine the target range for the federal funds rate. The federal funds rate is the interest rate at which depository institutions lend balances held either at the Federal Reserve or in their bank vaults to other depository institutions overnight. The current target range for this interest rate is 5.25% to 5.50%.

The current effective federal funds rate (the weighted average of the overnight rate assessed by depository institutions) is approximately 5.33%.

Financial chatter in the media about the Federal Reserve System tends to focus heavily on the central bank’s role in growing the economy. 12 U.S.C. 225a codifies the Federal Reserve System’s goal of maximum employment, stable prices, and moderate long term interest rates. Specifically,

“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.”

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What is lost on the public is that the role of the interbank market, a market partially regulated by the Federal Reserve System, lies at the heart of what the public perceives as the economy. For most people, the economy is an environment that creates jobs that people can compete for at wages that can put affordable food on the table, affordable electricity coming into the home, and affordable fuel in their vehicles. The generator of the capacity to provide these items, in this political economy, is a currency backed by a credit system.

For a majority of the working population, the currency in the employee’s pocket is sourced initially by a loan received by the employer from a bank. I first came to this realization as a bank teller many years ago while a student in Florida. Construction workers would come in every Friday to cash their checks, but nine times out of ten we would need some authorization to cash those checks because the account was overdrawn. Businesses borrow on the short term during those times of stress to meet payroll. I would wager that the amount of times an employee is paid from an employer’s unencumbered cash on hand is fewer than the times the employee is paid out of proceeds from a loan.

Regarding the currency itself, it is more than a payment system or token used to settle contracts or spot transactions. The currency is a political mechanism for legitimizing the government’s jurisdiction over the taxpayer-consumer-electorate. A currency that is severely devalued as a result of poor monetary policy, inadequate markets or reduced productive capacity will force consumers to look for alternative payment mechanisms. When that decision occurs, there will be a decrease in demand for government issued debt instruments i.e., U.S. bills, notes, and bonds. The government will fall into illegitimacy.

Behind the wording contained in 12 U.S.C. 225a is a less polished truth: the monetary policymaker does not want to see a run on the banking system where the system is deemed a failure. Monetary policy is about maintaining demand for the currency. The target range in the overnight rate as determined by the Federal Reserve System sets a base on which other lending rates are established. Lending boosts production and supply and demand for goods, services, and labor.

And while the Board of Governors of the Federal Reserve System sees itself as an independent agent of the government, it operates in and is sensitive to the political environment. The consumer sentiment it surveys reflects concerns for inflated food and rent prices, threats to hiring into or maintaining the labor force; and increasing difficulties in paying back debt.

If the public is experiencing stress, becoming more of a credit risk, will the banking system account for this stress by raising risk premiums and loading them into interest rates? Or will rates be reduced so that bank assets increase in value leading to a support of lending at lower rates?

Market sentiment is that the Federal Open Market Committee will maintain the current federal funds target range and likely reduce the target range as early as next June. Traders should consider how well the banking system maintains resiliency in the face of taxpayer-consumer-electorate sentiment.

Alton Drew

30 November 2023

(For my take on the political economy, purchase my book, “Take it from a Black Man. WASPs Need to Take Back Their Country” at amazon.com/author/altondrew )

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