Financial Update (April-June 1999)


Cover Story

Advice to the Fed

Strategies for the New Millennium


Year 2000

Did You Know?

Data Bank

The Docket


Federal Funds Market Plays
Important Role in Monetary Policy

C onducting monetary policy is one of the Federal Reserve's four main responsibilities. And the Fed uses three primary tools to conduct monetary policy — open market operations, the discount window and reserve requirements. But it's not so easy to count the ways that the reserve market influences and interacts with the economy or the ways the Fed influences the demand for or supply of reserves. All of the methods the Fed uses to influence the level and cost of financial institutions' reserves, however, pivot around one factor — targeting the federal funds rate.

The federal funds rate is highly sensitive to Federal Reserve open market operations, which influence the supply of reserves in the banking system.

Reserve Requirements and Federal Funds

All depository institutions in the United States are required by law to hold reserves based on a percentage of their transaction deposits. These reserves consist of cash in their vaults and balances in accounts at Federal Reserve Banks. Some financial institutions use their accounts at Reserve Banks not only to satisfy their reserve requirements but also to clear financial transactions; these institutions usually try to maintain a cushion of funds to protect themselves against unexpectedly large debits that could leave their accounts overdrawn and thus subject to a penalty.

To help them maintain their reserve accounts at their desired level, the Federal Reserve allows banks to actively trade reserves among themselves. Banks with surplus balances in their accounts transfer reserves to banks that need to boost their balances. These reserve balances that can be transferred between banks are called federal funds, and the rate of interest charged on the use of these funds is the federal funds rate.

Federal funds transactions neither increase nor decrease total bank reserves but instead redistribute them. This redistribution allows funds that would otherwise lie idle to yield a return.

Federal Funds' Role in Monetary Policy

By aiding the transfer of reserves among depository institutions, the federal funds market plays a major role in the execution of monetary policy. The federal funds rate is highly sensitive to Federal Reserve open market operations, which influence the supply of reserves in the banking system. For example, if the Federal Reserve wants to decrease the federal funds rate, it may purchase U.S. Treasury securities in the open market, thereby increasing the availability of bank reserves and, through market dynamics, putting downward pressure on the federal funds rate. To have the opposite effect, the Fed would sell Treasury securities in the open market.

In formulating monetary policy, the Federal Open Market Committee sets a target level for the federal funds rate.

Movements in the federal funds rate have a significant impact on financial institutions' loan and investment policies, especially commercial banks' decisions regarding loans to businesses, individuals and foreign institutions. Financial managers compare the federal funds rate with yields on other investments before choosing which combinations of assets to invest in or the term over which they will borrow. Interest rates on other short-term financial securities, such as commercial paper and Treasury bills, often move roughly in parallel with the federal funds rate. Yields on long-term assets like corporate bonds and Treasury notes are determined in part by expectations for the federal funds rate in the future.

Federal Funds Transactions

Federal funds transactions can be initiated by either a lender or a borrower. A bank seeking to lend funds identifies a borrower directly, through an existing banking relationship, or indirectly, through a federal funds broker.

The most common type of federal funds transaction is an overnight, unsecured loan between two financial institutions. Most overnight loans are booked without a contract. The borrowing and lending banks exchange verbal agreements based on several factors, particularly their experience in doing business together, and limit the size of transactions to established credit lines to minimize the lender's exposure to default risk. Such arrangements help speed up processing while keeping transaction costs as low as possible.

Many overnight federal funds transactions occur under a continuing contract that is renewed automatically until either the lender or the borrower terminates it. Unless the contract is terminated, the borrowing bank will continually roll the interbank deposit into federal funds, creating a longer-term, open-maturity instrument.

The most commonly used method to transfer funds between depository institutions is for the lending institution to authorize its district Federal Reserve Bank to debit its reserve account and to credit the reserve account of the borrowing institution.

Market Participants

All types of depository institutions — commercial banks, thrifts and credit unions — as well as agencies and branches of foreign banks in the United States, federal agencies and government securities dealers participate in the federal funds market. Many relatively small institutions that accumulate excess reserves lend these reserves overnight to money center and large regional banks and to foreign banks operating in the United States. Federal agencies also lend funds in the federal funds market.

Other financial institutions serve as intermediaries by borrowing and lending federal funds on the same day, usually channeling funds from relatively small to large banks. Broker firms earn commissions by arranging transactions between lenders and borrowers.