Tuesday, 23 May 2017

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Does the Fed set the rate?

October 23, 2014

It drives me nuts when people say the Federal Reserve sets the interest rate. Ditto for claims that the Fed raises or lowers the rate. Basically, any mention of rate setting by the Fed causes the whistle in my head to blow, as steam pours out from my ears. (Unless, of course, they are referring to loans made by the Federal Reserve… but they almost never are.)

These claims are usually in reference to the federal funds rate, the interest rate at which a depository institution charges another for borrowing funds held at the Fed. Such funds are called federal funds—hence the name. These loans are usually for very short durations—overnight—and, as such, the federal funds rate is occasionally referred to as the overnight rate.

Does the Fed set this rate? No. This rate is agreed upon by the institutions borrowing and lending overnight in the federal funds market. In fact, it is technically incorrect to refer to the federal funds rate since, on any given day, there is a range of rates being charged. The Federal Reserve Bank of New York collects data on the federal funds market. I’ve charted this data for the last month. The grey boxes mark the daily effective federal funds rate as a volume-weighted average of rates on trades arranged by major brokers. The vertical bands depict the range of rates prevailing on that day.

chart

The Fed does not set the federal funds rate. Rather, it sets its federal funds rate target. The distinction is important. Whereas setting the rate implies that the Fed directly determines the rate, setting the target makes clear that the Fed is merely conducting monetary policy in reference to the rate. If the rate is above the Fed’s target, for example, it will increase asset purchases, thereby increasing the rate of money growth.

To be sure, Fed policy affects interest rates. According to the Fisher equation, nominal rates equal real rates plus expected inflation, the latter of which depends in large part on the expected growth rate of money. And the Fed might even affect real rates in the short run through the portfolio and/or first-round loanable funds effects. Jeffery Rogers Hummel provides an excellent overview of these issues.

The point here is that the Fed does not set the federal funds rate. It sets its federal funds rate target. Recognizing this distinction is perhaps the first step towards a sophisticated understanding of what the Fed does when conducting monetary policy.