The Fed: Stripped

Ok, now as great as I think Federal Reserve Chairman Ben Bernanke is, I don't actually want to see him stripped. But, any Joe can see that the Federal Funds Rate is pretty important to market participants. In the days leading up to the rate decision, the day of, and even a few days after market coverage, which can be pretty ADD if you ask me, focuses on what the Fed is going to do. So here's my shot at shedding some light on more than just the actual rate decision.

US banks are required to keep a certain amount of reserves on hand and in the US's central banking system (also known as the Federal Reserve) there is an open market between and among the banks and the Fed. In short, the Federal Funds Rate is the prevailing rate that banks are borrowing money for their own reserves. The reason that the Fed's statements always say that the rate is a "target" is because it doesn't just say to the banks "this is the rate you can borrow at," but rather it makes more or less money available to lend and based on supply and demand dynamics the prevailing rate changes.

The Fed Funds Rate then ripples through the economy as the banks adjust the rates that they offer loans at and the interest rate they offer to pay for deposits. In general, the best loan rates that the banks will offer will be at some premium to the Fed Funds Rate, and on the flip side, they're not going to pay more for deposits than the Fed's rate.

On the loan side, if you think about the decision by companies on whether to take on new projects, one of the key considerations is whether the payoff from the project is going to be above the cost of the capital needed to take on the project. As the rate at which firms can borrow, more projects will be taken on and economic expansion will increase. Likewise, as loan rates go up, it will make less sense to take on some projects and it will throw a big wet blanket on economic expansion. While I wouldn't say that the Fed can make or break the economy, it's easy to see how they wield a lot of power over the economy.

So next, the question is: why don't they just put the rate at zero (where Japan's has pretty much been for a while) and watch as our economy soars? The answer to this is that economists have an idea that there is a "sustainable growth rate" for our economy. Above this sustainable growth rate we start to run into problems like firms competing for resources and causing inflation.

As an example, imagine this: our economy is going crazy and growing like a weed (or could we say like China?). Companies are tripping over themselves trying to grow as fast as they possibly can, and as this happens they need to find more workers and more machines for the workers to work on. Now there are only so many available workers, and there is also only a certain amount of available machines (this can be increased faster than the number of workers, but it still takes some time). Thinking supply and demand, as supply stays relatively fixed and demand goes way up, prices head up. When prices start increasing out of control, as might happen in a hyper-growth scenario, you get inflation. Inflation is a topic all by itself, but suffice it to say that it's not good for confidence in a country's currency and likewise not good for the economy.

So keeping the economy at the sustainable growth level keeps us moving up and to the right maybe slowly, but certainly steadily. Unfortunately, there is no real way to easily quantify what this sustainable rate is, and there are plenty of ways that the sustainable rate might change over time (think supply of resources or technological change). The challenge for the Fed is to try and figure out what the sustainable rate is for our economy and when we fall below that, loosen the money supply to try to nudge growth forward, and when we are rising above that, tighten the money supply to damper growth.

Now if you're still with me on this unusually long post, besides having an effect on the overall economy, the Fed's rate does also have a more direct effect on the stock market. First off, as the interest rates that banks offer on deposits goes up it becomes increasingly competitive with the stock market. Thought the returns that you can get from, say, a money market account are pretty much always going to fall well below what you can get from the stock market, the returns are basically risk free. So as interest rates go up, you'll have more people that say 5% risk free? I'll take it. So they pull their money out of stocks (stocks go down) and put them in, say, a nice money market account.

Another way that the rates effect the stock market are margin lending rates. For people that want to buy more stock than they can afford with their own cash, they can borrow against a margin account. When margin rates are low, it will make sense to borrow a lot on margin and buy more stock -- if you can borrow margin at 7% and expect 11% from the market that's a pretty good tradeoff right? But as rates go up and you're paying 10.5% on margin to get those 11% returns, there are going to be far fewer people buying extra stock on margin.

So hopefully this helps elucidate the Fed's operations a little more. If you want to dig a little further, the Fed's page on open market operations is a good place to start (the link to the article on this page is worth following).

-AvgJoe