When the fed sets the rate is it on the money the banks take from the fed or the money the people take from the banks?
I’m pretty sure it is the rate at which the banks borrow from the fed.
The former.
The Fed sets two rates - the Fed Funds rate and the discount rate.
The Fed Funds rate is the rate at which banks borrow from each other overnight to meet their reserve requirements. The Fed maintains this rate by open market operations - i.e. by buying and selling treasuries to the 20 or so primary dealers.
The discount rate is the rate at which a bank borrows from the Fed directly. This is set at a small premium to the FFR, to discourage banks from using it for other than short term exigencies.
The Fed does not set long term rates.
If the banks have to pay back the fed when does the money creation come in?
“If the banks have to pay back the fed when does the money creation come in?”
The banks get relatively little money from the Fed. Banks create their own money in the form of bank deposits. They do this whenever they lend money.
Modern money is just debt. Currency is the debt of the Fed, and bank deposits are the debt of the banks. The Fed can create money (i.e. increase its debt) just by drawing a check on itself to buy an asset - usually a US treasury note. A bank creates money (i.e. increases its debt in the form of a bank deposit) when it creates a loan.
A bank issues far more debt that it could honor, if everyone demanded redemption in currency at the same time. A bank therefore relies on the Fed to supply it with currency to meet any such demand.
I’m not sure that’s entirely true. The Fed sets rates by buying or selling securities from the market - typically government treasuries (bonds). If they buy more of these bonds they drive up the prices and thus drive down the yeilds. Since government bonds are generally considered to be risk free, the yeild on government bonds is generally considered to be the risk free rate of interest.
However, the rate that banks lend to one another is a completely different kettle of fish and one aggregate measure of this is the LIBOR. The spread between the rate that banks lend to one another and the yeild on bonds gives you a pretty good idea of how much the banks trust one another and how nervous everyone is - which is particularly relevant today since this spread is sky high. However, the Fed has no direct control over this spread or the rates that banks lend to one another - it can only inject money into the market (by buying bonds and other assets, to drive the price of those assets down) or set the discount rate at which it will lend to banks directly.
At least, that was my understanding of the process by which the Fed set interest rates… please correct me if I’m wrong about any of this.
My understanding is that the Fed does not buy securities for the purpose of changing the yield on those securities, though that may indeed be a side-effect. Its purpose is to increase bank reserves (since the Primary Dealers deposit their Fed-checks in Depository Institutions) and hence to lower the short term Fed Funds rate of interest in the Fed Funds market (which consists of bank reserves). Likewise the Fed sells securities to decrease bank reserves and raise the FFR.
Indeed, if the Fed uses Repos (temporary transfers) then the securities bought and sold are - in economic terms - nothing more than collateral for what is - in economic terms - simply a loan. The price paid has no implications for the yield.
I should have qualified my statement to read “borrow in the Fed Funds market”. Yes, LIBOR is the market equivalent. Comparing the FFR to LIBOR tells us whether the Fed is being loose or tight.
Cheers
Hm, I wonder where we can get a definitive answer to this then… since I’m still not convinced. My understanding, which seems to conflict with yours, is that other than the discount rate the Fed doesn’t directly/explicitly set any interest rates. Typically when it lowers or raises interest rates it does so by setting a “target rate” which it then directs the primary dealers to try to achieve through the purchase/sale of securities… through the process I described above (by pushing up or down the yields on bonds). Thus if the target rate was lowered and the market itself didn’t want to buy more bonds then the implication would be that the Fed’s agents would have to inject new money into the markets in order to buy those securities (which would drive up the price, drive down the yeild and thus drive down the “interest” paid on money leant to the government).
But this certainly isn’t the picture you’ve painted of all of this… I’m wondering if De Soto has this in his book (which has been sitting on my desk for far too long now - I’ve simply been too busy to read it). I’ll see what I can dig up.
btw: I think comparing those two figures will tell you something about how banks view one another, in terms of risk. A better indicator of whether the Fed is being loose or tight is probably MZM - i.e. the amount of new money they have to pump into the markets to achieve their “loose” target rates (or, less often, the amount of money they take out of the markets when selling their securities back to the market). Excuse me if I’m starting to sound like a pedantic b@#$#%d - not at all my intention. But I think the truth or falsehood of my comments here will depend on which one of us turns out to be right (if either) concerning the way the FFR works.
These links might help:
http://wfhummel.cnchost.com/banklending.html
Yes, the Fed doesn’t set the FFR directly, only a target FFR. But it manipulates bank reserves to reach that target.
Yes, my favorite measure of the money supply is MZM. That also helps in understanding how tight or loose the Fed is. But the Fed doesn’t control MZM (except indirectly via interest rates) - the banks do. The Fed is responsible only for M0 - currency & bank reserves. And it’s a long time since bank reserves kept bank loans on a tether, except through the Basel capital requirements.
Interesting article - fairly easy to follow. I was also reading up at:
http://en.wikipedia.org/wiki/Federal_funds_rate and
http://en.wikipedia.org/wiki/Open_market_operations
So what I don’t quite understand is this - the banks all need to maintain certain reserves (in order to comply with their reserve requirements). In order to achieve this, it is explained, they often lend money to one another (a bank that has surplus reserves could lend to a bank that has insufficient reserves, for an appropriate level of interest and it is this level of interest that the Fed hopes to control by setting the FFR.
What then, do securities (such as treasuries) have to do with it? How does buying or selling treasuries affect the interest rate that banks are willing to lend to one another at? Is it simply assumed that because buying securities from the market pumps money into the system (and increases the ratio of reserves available to reserves required) that the interest rates will adjust accordingly, given a sufficient delay?
One other thing that you might know the answer to - how does foreign exchange come into the equation? For example, imagine some company in the US buys some wine from Austrialia. Some bank in Australia ends up with some US dollars, which were deposited by the Austrialian winery - and which the bank can presumably sell to it’s central bank, increasing the quantity of reserves they hold at the central bank. As such, presumably a trade surplus would put downward pressure on interest rates and a trade deficit would put upward pressure on interest rates - is that correct? So the central banks of countries with trade deficits are required to buy more securities (and pump more money into the market) to keep their interest rates stable than countries with trade surpluses (all other things being equal, of course).
Presumably foreigners buying bonds adds yet another layer of complexity. For example, when the Chinese buy US bonds they’re paying in US dollars - so they’re pumping money into the system (which the US banks can use as reserves for increased loans). If foreigners sell bonds then they’re taking money out of the system (which the US banks no longer have as reserves).
Does all of the above sound kosha?
The securities are a red herring. The Fed trading desk effectively lends or borrows money in the fed funds market to maintain the FFR. These loans are known as Repos (repurchase agreements), because technically they are an agreement to buy and sell back securities at some nominal price. In economic reality, the securities are nothing more than collateral for the loan.
If the Fed uses open market operations to buy/sell securities at market prices (instead of Repos), then that is for the purpose of making permanent changes to the monetary base.
If a US company orders wine in Australia, priced in AUD, then it must first change its USD to AUD on the forex markets.
If the wine company exports wine to the US, and prices it there in USD, then the wine company would then sell its USD earnings for AUD on the forex markets.
The RBA (Reserve Bank of Aust), as far as I remember, is fairly non-interventionist and engages relatively rarely in forex transactions.
Central banks of countries with freely traded currencies tend to trade on forex markets only for the purpose of propping up or lowering the value of the currency.
If a country (say the US) is running a net trade deficit, then some other country must be running a net trade surplus (say AU). That implies that AU will end up with a surplus of USD. But those USD are just sitting in a US bank account which now has an Australian owner. If the Australian owner exchanges it on the forex markets, then the USD will be transferred to a US account owned by the forex dealer.
At any rate, whosever account the surplus USD ends up in will either withdraw it as currency (uncommon), spend it, or invest it (and that includes holding it in the account, since all bank deposits are loans to the bank). If it invests it, e.g. by buying bonds or shares, then that will help keep interest rates low. Massive Asian investment in US bonds has indeed kept USD interest rates low.
Only withdrawal of cash as currency will actually remove money from US banks. The effect of such hoarding would be to increase the demand for USD, which would lower the price of US goods, which would in turn make it more attractive to spend the hoarded USD.
Trade deficits can persist only for as long as the surplus nation is willing to invest its surplus in the deficit nation. The distortion in US world trade at present is due to the Asian mercantilist desire to keep their currencies low. Long term USD interest rates are low, courtesy of the Asian taxpayer.