I'm not entirely sure what you're asking here. What banks, and lend to who? In general banks will lend to people/institutions in the real economy above the FFR rate. This is how banks earn money. They lend at a rate above FFR and earn a spread.
Although I have to admit, bank operations and profitability is a topic I'm fairly weak on. It's actually going to be a research area for me in the next six months or so, and at this point I can't offer a whole lot of insight.
I am referring to the situation where commercial banks lend to reserves to each other. I am trying to understand the mechanics of how we go from "The Fed announces a FFR increase" to "the Effective Federal Funds rate moves in response to that increase".
Here is a graph of the FFR range and the Effective Federal Funds Rate (seems to be the actual / freemarket rate at which money is lent):
The Fed sets two rates, FFR and IORB which used to be called IOER. This is the overnight lending rate. Sets a market floor because why would a large bank/primary dealer lend to another institution at a lower rate, when they can earn risk free from the Fed. IORB is at 4.4% right now, so right in line with FFR
how do short term interest rates match the FED funds rate?
Are there some sort of open market operations that move all short term interest rates to the FFR? Or does the FED just say "short term interest rate is now X" and then commercial banks adjust all rates?
Well the Fed has two tools to set short term rates. FFR and the repo rate. So let's say the Fed sets FFR at 5%, that creates an incentive for major market players like Goldman or JPM or whoever to sell short term bills and invest that money at the Fed. Why hold a short term bill yielding 4% if you can invest with the Fed and earn 5%, for example.
So generally speaking you expect short term rates to match whatever the Fed sets, however, where it gets interesting is that there can be huge demand for t-bills as collateral such that rates could actually get driven below FFR. That's another topic entirely though.
I imagine that this is the same dynamic that happens to longer term T-bills. If the Treasury sells 10y T-bills at 5%, and the market rate is 2%, then people will sell the bills yielding 2% for them and purchase the fresh 5% 10y T-bills?
Your language needs some updating. We have bills, notes, and bonds. Bills are 1 year duration and less, notes are 1 - 10 year duration, bonds are 10 - 30 year duration. So you have a 10 year note not a bill.
I think you're missing a concept here and I'm trying to figure out what exactly it is. I think the problem is that perhaps you're not grasping duration. The point of this article is to talk about the Fed's influence on short term rates, not long term rates. So when you're talking about 10 year notes, we're talking about a yield that the Fed doesn't necessarily directly control. I mean, just look at the 10 year right now. It's yielding 3.75% while FFR is 4.3%. So we have an inverted yield curve where longer maturity debt trades below short term rates.
Also, I was going to write this earlier but I kept putting it off. I think another concept that perhaps you're missing is that rate changes are constantly getting priced in by the market. It's not as though the Fed moves rates and then magically bill rates make a huge move on that day. No. Bills trade in the market and as the market anticipates a Fed rate hike the bills will sell off well in advance. By the time a rate hike is actually implemented, the yield on a bill might not move at all because it's already priced in. The yield might only change if the Fed does something unexpected, like raise more/less than the market was anticipating.
I see what you are saying concerning the market expectations now. For instance, the Fed has been firm that it will continue to increase interest rates at a lower rate. It is reasonable to expect that people will buy / sell treasuries ahead of time based on the expectations set by the Fed. So once the announcement takes place, it was already "priced in".
I imagine these expectations would also play into the price of newly auctioned 10 year notes.
Yeah I mean an institution has a choice, they can buy a 10 year note in the open market, or from the Treasury. So market participants are only going to be willing to pay the Treasury the going market rate for that note.
Have a look at the yield curve, which is constantly changing. That can give you a good idea of where the market is pricing rates. If you look at the 3 month note, for example, you can get a general idea of where the market thinks FFR will be in 3 months. Although this is not an exact science per se, and is more useful as a directional trend.
Also, are banks required to lend within the Federal Funds Rate? aka does the Effective Federal Funds Rate always have fall within the FFR range?
I'm not entirely sure what you're asking here. What banks, and lend to who? In general banks will lend to people/institutions in the real economy above the FFR rate. This is how banks earn money. They lend at a rate above FFR and earn a spread.
Although I have to admit, bank operations and profitability is a topic I'm fairly weak on. It's actually going to be a research area for me in the next six months or so, and at this point I can't offer a whole lot of insight.
I am referring to the situation where commercial banks lend to reserves to each other. I am trying to understand the mechanics of how we go from "The Fed announces a FFR increase" to "the Effective Federal Funds rate moves in response to that increase".
Here is a graph of the FFR range and the Effective Federal Funds Rate (seems to be the actual / freemarket rate at which money is lent):
https://fred.stlouisfed.org/graph/fredgraph.png?g=1RLI&height=400&nsh=1&trc=1&width=600
I think what you're looking for is IORB
https://fred.stlouisfed.org/series/IORB
The Fed sets two rates, FFR and IORB which used to be called IOER. This is the overnight lending rate. Sets a market floor because why would a large bank/primary dealer lend to another institution at a lower rate, when they can earn risk free from the Fed. IORB is at 4.4% right now, so right in line with FFR
how do short term interest rates match the FED funds rate?
Are there some sort of open market operations that move all short term interest rates to the FFR? Or does the FED just say "short term interest rate is now X" and then commercial banks adjust all rates?
I am interested in these mechanics.
thx!
Well the Fed has two tools to set short term rates. FFR and the repo rate. So let's say the Fed sets FFR at 5%, that creates an incentive for major market players like Goldman or JPM or whoever to sell short term bills and invest that money at the Fed. Why hold a short term bill yielding 4% if you can invest with the Fed and earn 5%, for example.
So generally speaking you expect short term rates to match whatever the Fed sets, however, where it gets interesting is that there can be huge demand for t-bills as collateral such that rates could actually get driven below FFR. That's another topic entirely though.
I imagine that this is the same dynamic that happens to longer term T-bills. If the Treasury sells 10y T-bills at 5%, and the market rate is 2%, then people will sell the bills yielding 2% for them and purchase the fresh 5% 10y T-bills?
Your language needs some updating. We have bills, notes, and bonds. Bills are 1 year duration and less, notes are 1 - 10 year duration, bonds are 10 - 30 year duration. So you have a 10 year note not a bill.
I think you're missing a concept here and I'm trying to figure out what exactly it is. I think the problem is that perhaps you're not grasping duration. The point of this article is to talk about the Fed's influence on short term rates, not long term rates. So when you're talking about 10 year notes, we're talking about a yield that the Fed doesn't necessarily directly control. I mean, just look at the 10 year right now. It's yielding 3.75% while FFR is 4.3%. So we have an inverted yield curve where longer maturity debt trades below short term rates.
Also, I was going to write this earlier but I kept putting it off. I think another concept that perhaps you're missing is that rate changes are constantly getting priced in by the market. It's not as though the Fed moves rates and then magically bill rates make a huge move on that day. No. Bills trade in the market and as the market anticipates a Fed rate hike the bills will sell off well in advance. By the time a rate hike is actually implemented, the yield on a bill might not move at all because it's already priced in. The yield might only change if the Fed does something unexpected, like raise more/less than the market was anticipating.
Thanks for the language update!
I see what you are saying concerning the market expectations now. For instance, the Fed has been firm that it will continue to increase interest rates at a lower rate. It is reasonable to expect that people will buy / sell treasuries ahead of time based on the expectations set by the Fed. So once the announcement takes place, it was already "priced in".
I imagine these expectations would also play into the price of newly auctioned 10 year notes.
Yeah I mean an institution has a choice, they can buy a 10 year note in the open market, or from the Treasury. So market participants are only going to be willing to pay the Treasury the going market rate for that note.
Have a look at the yield curve, which is constantly changing. That can give you a good idea of where the market is pricing rates. If you look at the 3 month note, for example, you can get a general idea of where the market thinks FFR will be in 3 months. Although this is not an exact science per se, and is more useful as a directional trend.