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The economic importance and limitations of the Fed funds rate

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Charles Plosser on forward guidance for the Fed funds rate

Dr. Charles Plosser, President and Chief Executive Officer of the Federal Reserve Bank of Philadelphia, spoke at the Council on Foreign Relations in New York on May 8, 2014. The topic for discussion was “Communication and Transparency in the Conduct of Monetary Policy.” In his speech, Dr. Plosser emphasized that the Fed should follow a systematic approach to determining the monetary policy. The process of determining the Fed funds rate should be communicated in a transparent manner and the Fed should also provide the financial markets with forward guidance as to the rules that would determine its likely future path.

Part 2
What is the Fed funds rate?

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The Fed funds rate or the base rate, is the rate at which depository institutions like banks make overnight loans to each other within the Federal Reserve System. The U.S. Federal Reserve uses open market operations (that is, purchase and sale of Treasury securities) to effect changes in the Fed funds rate. The base rate is the main benchmark rate for the U.S. economy.

Importance of the Fed funds rate as a monetary policy tool

The Fed uses the base rate as one of its main tools to control the course of monetary policy. When economic growth is flagging, the Fed can lower the base rate so that businesses are incentivized to boost investments in the economy, as their cost of funding also becomes lower. Higher private sector investments would generate employment and provide traction for economic growth, all else equal. When the economy is overheated, the Fed can increase the base rate, which in turn, increases the cost of funding for businesses (for example, companies in the S&P 500 Index (SPY)) who are forced to reconsider investments in the light of their higher borrowing costs.

Importance of the Fed funds rate for financial markets

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Although the Fed funds rate is short-term and applicable only to inter-bank borrowings within the Federal Reserve System, any change in the base rate usually translates to other borrowers and maturities. For example, the prime rate, which is the rate banks like J.P. Morgan (JPM) charge their most credit-worthy borrowers, is determined by adding a spread over and above the Fed funds rate. So, corporate borrowers included in the iShares Core Total US Bond Market ETF (AGG) as well as issuers of municipal debt like those included in the iShares National AMT-Free Muni Bond ETF (MUB) are all affected by changes in the Fed funds rate.

Limitations of the Fed funds rate as a monetary policy tool 

In recent years, the use of the Fed funds rate as a monetary policy tool has been exhausted as the base rate is constrained by the zero lower bound (or ZLB). The base rate has been in the range 0% to 0.25% since December 2008, as the Fed tries to spur economic growth following the Great Recession and financial crisis. This has removed the scope for further decreases in the base rate, as the rate can’t go below zero.

However, the Fed’s purpose in keeping interest rates at record lows may have been thwarted; corporate borrowers have used the opportunity to borrow at low rates and deploy the funds in financing share buybacks and funding acquisitions, some of them not even in the U.S. For example, in January 2014, the largest brewer in the world, Anheuser-Busch InBev (BUD) issued $5.25 billion in fixed and floating rate debt in the U.S. markets to fund its acquisition of South Korean brewer, Oriental Brewery. Anheuser-Busch InBev (BUD) is part of the S&P 500 Index (SPY), which is composed of the 500 largest publicly-listed companies in the U.S.

Dr. Plosser’s take on systematic forward guidance for the Fed funds rate

Dr. Plosser, in his speech on May 8, said that the ZLB was one of the key reasons markets were paying greater attention to the future path of the Fed funds rate. “So when, or under what conditions, the nominal policy rate might eventually rise takes on greater significance,” said Dr. Plosser.

In the next part, we will discuss Dr. Charles Plosser’s comments on forward guidance.

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