Tag Archives: Fed Funds Rate

Fed Officials Expect Overshooting Unemployment Rate

Following the Fed’s March 18-19 meeting, the policy making committee provided a collection of charts showing the projections of macro economic main variables in the coming years. Before discussing the projections, I should note here a little bit of confusion I have. In the projection file, it states that these projections are “based on FOMC participants’ individual assessments of appropriate monetary policy.” Therefore, these number’s aren’t actually projections as done by someone outside of the Fed, but these are the expected values of these economic variables that could be seen according to Fed officials’ own appropriate policy. 

In other words, when looking at these projections, we should take into consideration that these projections are influenced by each committee member’s policy recommendation.

The recent post on the WSJ touches on how this projection could be misleading the market into expecting that interest rate rise will come sooner than expected. According to the article, some Fed’s policy committee members raised their expectation of interest rates in 2015 and 2016. This could signal market that the Fed policy makers are looking at possible rate increase which is sooner than expected prior to March meeting.



From the above chart we could see what rate Fed officials are expecting fed funds rate target to be in 2014, 2015, 2016 and long-run. In 2014, according to the chart, we see that the policymakers almost unanimously expect the fed funds rate target be at the current level of 0 to 0.25 percent target. In 2015 and 2016, the averages of the Fed officials’ expected fed funds rate are around 1 percent and 2.5 percent, respectively. The policy makers expect the rate to be around 4 percent in the long-run. This rate is slightly lower than the historical average of the fed funds rate target since 1990, which is 4.2 percent. In general, the committee members expect to have similar fed funds rate target that it has had since 1990.

Note that, the expected fed funds rate target is still lower than long-run expected rate of 4 percent at around 2.5 percent in 2016. Hence, it is plausible that somewhat easy monetary policy will be taking place until 2016. But we should always remember that low interest rate doesn’t always mean expansionary monetary policy as Milton Friedman put it, “After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die.”

The surprise of the projection comes when we look at another chart which was included in the same projection report. The following chart shows how the committee members expect the unemployment rate to be under appropriate policy in coming years and in the long-run.



The central tendency among the policy makers regarding the expected unemployment rate in 2016 is along with the long-run projection: at 5.2-5.6 percent.

So, what can we conclude about the Fed’s future policy from these two charts?

The Fed policy makers are believing (or seems to be) that under appropriate policy, the Fed will be pursuing expansionary policy even after the unemployment rate reaches the long-waited long-run average. In other words, the Fed policy makers think overshooting the unemployment rate is a viable option for the Fed policy in coming years. This is along the line with the worry about low inflation in coming years. Another chart in the projection shows how the policy makers expect inflation to be in coming years.FedINflation


As we see from the chart that central tendency among the officials regarding the expected inflation in 2016 is below the Fed’s target of 2 percent inflation. It is kinda counter-intuitive; they target 2 percent, but expect it to be below it. Or are they really targeting 2 percent?

Then, given the the below target inflation rate, the Fed officials shouldn’t be worried about their fed funds rate target expectation below the long-run expectation.

From the Fed officials’ projection, we can conclude that the Fed will be still operating somewhat stimulus policy in 2016 relative to their long-run policy.– if we assume these projections are made with rational expectation

Fed fund rate: not as simple as it seems. (2nd post)

This is the second post from my series of discussions of fed fund rates.

We learnt form traditional text book that the FED use target fed fund rate and OMO to guide the banks in changing the demand for fed balance. However, text book can be obsolete in the sense that they reflect the past, whereas new policies continue to enact.

As I said in my last post, according to John Taylor, effective fed fund rate (I will use effr for short) has become increasingly less related to OMO. The rate tend to move to new intended level as soon as the bank knew the rates.  Apart from the reason discussed in my last post that fed fund targets become more explicit, there are other two reasons.

First, since July 1998 the Fed had changed from a contemporaneous system of reserve accounting to a lagged system. What do I mean by the nerdy phrases “contemporaneous” and “lagged”? In a lagged system, the amount of legally required reserves for a bank at a particular day is not the estimates for that day, but a number calculated almost a month ago. Why take so long? The legally required reserve is not arbitrary number but a estimates from the total amount of demand deposit at a bank. Longer the estimation time, more accurate the results. There are typically two weeks for fed and the bank to estimate the demand deposit, and after that, there is another 17 days for the reserve maintenance period to start. Reserve maintenance period is a period of two week where bank should maintain on average the required demand deposits.

What’s the effect of this lagged reserve accounting system? How does it help explain effr change even before OMO? Well, this has eliminated any contemporaneous response of required reserves to the fed fund interest rate. That is, once the fed change the target rate, the demand for required fed balance by the bank does not change because the reserve requirement is established a month ago. Effr changes before OMO not because the demand for required balance changed, but because the bank foresee that Trading desk will step in and change the supply of fed balance, making effr in line with target rates. The change in effr is more out of rational expectation than out of change of need for required fed balance.

The other reason for this decreasing correlation between OMO and effr is that modern technology and, if you will, the more and more versatile bankers, facilitate the emergence of “sweep” account. Banks “sweep” their customers accounts from those with reserve requirement to those without reserve requirements. Typically, the bank can sweep the checking account  into more lucrative Money Market Mutual Funds. Therefore, as I mentioned above, during reserve computation period, fed find the amount of required reserve requirement continue to decline. Therefore, meeting required reserve is not the most important motivation for transaction flows in Fed Fund markets. As John Taylor put it, holding fed balances to facilitate interbank payments is of greater importance for many banks than holding reserves for legal requirement. Thus, when fed change the target rate, the market anticipate the OMO as well as changes of supply for balance. They anticipate that OMO will bring effr to its targets,  therefore the demand is changed more due to arbitrage opportunities then due to meeting legal requirements.

Another evidence that fed fund markets plays more than a role of helping member banks meet reserve requirements is the fact that,  the flow of trade in the federal funds markets is more than ten times greater than the stock of fed balance. Banks typically buy funds in the market to make loans in other markets. Fed funds purchases are a source of funds for other loans creates a connection between the federal  funds rate and the other loan rates.



Rising Interest Rates

In the aftermath of our most recent exam were back at it again, blogging about current topics in the world economy. After spending many hours studying Professor Kimball’s material I found it only fitting that when I logged on to the Wall Street Journal the main page housed an article about the Fed debating on the appropriate time to raise the fed fund interest rates. The Fed has already began backing off Quantitative Easing strategy and allowing the interest rates to rise on both ten year treasury bonds and longer mortgage back securities. The FOMC meeting again agreed in January to cut assets purchases by another $10 Billion in the upcoming month, dropping the total to $65 Billion in the month. Many people except the Fed will continue cutting asset purchase by $10 Billion a month for the foreseeable future.

The article in the journal also addressed the Feds most current debate on allowing the federal funds rates to rise sooner than the previous target of 2015. The entire board was not in favor of the increased timeline, however at least two of the members found it appropriate to start the discussion of lowering the rates within the next six months, or possibly sooner. These members found that data points showing strong economic growth may warrant shortening of the time line.

There seemed to be two sides to the argument. Some argued the housing markets and job markets weak ending in January are both signs that the Fed Funds rate should remain pinned at zero, and even went as far as voicing the opinion to back off the constant cuts of $10 Billion a month. The opposing side argued back that these weak data points were a direct result of an extremely cold winter and expect them to bounce back to normal growth levels by in the short future.

My personal opinion is that the Fed should allow the fed funds rate to start creeping up past the zero lower bound its bin pinned at for the past five years. I think the Fed buying back up the 3-month treasury bills before it has completed its quantitative easing strategy would be beneficial. If all the high powered money came back “alive”, they would be able to quickly buy it up before an economic disaster. Starting to raise the fed funds rate before quantitative easing is completely undone will also work as a safe guard, since all interest rates are tied together it is unlikely the fed funds rate will surpass rates on longer term assets.