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Saturday, April 30, 2011

What is the Federal Funds Rate?

The federal funds rate is the rate banks pay each other for borrowing reserves. The Federal Reserve, the nation's central bank, requires banks to hold reserves against deposits. The Federal Reserve controls the federal funds rate. In effect, it is the price of money that they control.

Understanding the record in controlling this important price is key to understanding the housing crisis and the legacy of former Federal Reserve chairman Greenspan and the role of current chairman Bernanke.

Source: Baltimore Sun
As shown in the graph, the Federal Reserve lowered the rate to the unprecedented level of 1% in mid-2003 and kept it there for a year. Why? The party line was that the Fed was worried about economic weakness. This was after the dot-com meltdown in the stock market and the 9/11 attacks. Inflation had ratcheted down and  deflation was a worry. Looking over their shoulders, Fed governors saw Japan mired in a long-term economic slowdown because they didn't act aggressively  with macro economic policy.

But how weak was housing? The graph shows that single-family housing sales were on the upswing in 2003 as the Fed was aggressively cutting rates! Compare where housing sales were then to today, and think about the Fed and many others wondering why unemployment persists at such a high level.

Of course, all of this is history.  The Fed held the rate at 1% for a year starting in mid-2003 as the housing market went ever skyward!. Exotic mortgages were created. Mortgages were made with no down payment, no income requirements, and even the ability to have the principal increase over time as a payment option. Chairman Greenspan actually encouraged home buyers to use adjustable rate mortgages and take advantage of low teaser rates.

Gasoline was poured on a roaring fire. Bankers packaged and sliced and diced and manipulated ratings to push mortgage-backed structured product around the world. 

Then the Fed pulled the rug out from under the housing market. As shown in the first graph, they pushed the fed funds rate from 1% to above 5%. Again, the rest is history. Housing prices faltered, foreclosures rose, and the securities started to fall in price.

Today the federal funds rate is close to zero and has lost its capability to enable a pick-up in the economy. After all, it can't be pushed into negative territory.  Instead the Fed has come up with a new policy approach - "quantitative easing."  Quantitative easing is essentially an attempt to control the price of longer term money.

Part of the reason for the Chairman's recently instituted press conferences is to convince the American public he knows what he is doing.

Based on the record, I, for one, am not convinced.


  1. Very good explanation Robert! In my opinion, no one is more responsible for the state of affairs than Greenspan. I might even give 'the' Bernake some credit - it isn't easy to NOT make mistakes when you have something, as rotten handed down as our current economy today.

  2. @MoneyCone It's too bad we can't replay everything with the Fed holding the rate at 3% rather than pushing it to 1%. I think we would have still had a downturn but nothing like what happened.