“And the Federal Reserve is a...prison?” - Detective Terry Hoitz, The Other Guys
If you haven’t seen it already, go rent The Other Guys. You will not be disappointed. It has one scene in which Mark Wahlberg’s character, Detective Terry Hoitz, and Will Ferrell’s character, Detective Allen Gamble, listen to an SEC employee attempting to explain the function of the Federal Reserve. Mark Wahlberg refuses to be educated and continues to believe that the Federal Reserve is a jail where he can lock up criminals. Will Ferrell’s character remarks in frustration, “He still doesn’t understand the concept.”
Well, I really hope Mark Wahlberg is reading this post (I can only assume he spends his downtime perusing my blog). Central Banking, of which the Federal Reserve is just one example, is one of the most commonly misunderstood concepts in the world. I had no idea what the Federal Reserve was until I was probably 24; even then, it took me 8 years and an MBA to gain a really deep understanding. I’ve spent a lot of time studying the Federal Reserve (or “The Fed” in common parlance). In fact, I took a vacation day in 2013 to tour the Federal Reserve building in Atlanta, something my wife views as nerdier than driving a DeLorean to a Star Trek convention dressed as Gandalf.
Though the average person might not grasp all of the functions of the Fed, I think most people have a vague understanding that the Fed sets interest rates. But what does this really mean? Is the Fed actually telling banks what rates they can charge on loans? I don’t want to focus on the goals or historical results of the Fed at this time; the subject is far too complicated for one short post and I don’t feel fully-qualified to write it. What I want to do is to attempt to describe what interest rates really are and how the actions of the Fed affect these rates. I hope that this will done at a level that will bore an economics major, be fairly insightful to an MBA, and be a thunderbolt of information to someone without a business education (Mark Wahlberg, I’m sorry, but I’m assuming you’re in the last category). Alright, here we go!
I think that most people realize that when you deposit money in the bank, the bank doesn’t actually take all of your money and store it in a vault. Some of it is placed in a vault and the rest is loaned out to other individuals or institutions in need of capital. The idea is that, if you want your money at some point, you will be just as happy if the bank pays you back with someone else’s money as your own. The concept is referred to as fractional reserve banking and it is the foundation of our financial system.
But wait. What if everyone wants their money at the same time? The bank can’t pay everyone with someone else’s money. This causes a run on the banks, where everyone tries to rush to get their money out before it’s all gone. In order to ensure this doesn’t happen, the Fed has instituted a reserve requirement of 10%. This means that the bank can only loan out 90 cents for every dollar that you deposit, and it is supposed to instill stability in the system.
So what happens at the end of the day when a bank only has 9% or 8% of its total deposits in reserve? In order to not run afoul of the law, the bank does what anyone else does when they need money: get a loan! And who would want to make an overnight loan to a bank? Usually, it’s another bank that has reserves in excess of the reserve requirement. Since the extra money will not earn anything sitting in the vault, banks are happy to make an overnight loan to other banks in need. The rate at which banks will loan each other money is referred to as the Federal Funds rate, despite the money not coming from federal funds. Though the Federal Funds rate is referred to as if it is one discrete number, it is actually a target range of interest rates that banks charge each other.
How does the Fed come into play? Banks also have the option of borrowing from the Fed at a set rate, referred to as the discount rate. The discount rate is higher than the Federal Funds rate, causing banks to prefer to borrow from other banks. But due to the simplicity of the transaction, banks still chose to borrow from the Fed sometimes. While the Fed does not directly dictate the rate that the banks can borrow from each other, the simple fact is that the discount rate sets the ceiling for the Federal Funds rate. If a bank is offering a rate on overnight loans at or higher than the discount rate, banks would simply prefer to borrow from the Fed at the discount rate. After all, the Fed has unlimited funds that it is always willing to loan at a predetermined rate, making the search for funds very simple.
But who cares about the rate on overnight loans between banks? Well, if a bank can borrow money very cheaply to make up a shortfall with regards to the reserve requirement, that bank is much more likely to aggressively lend out money to individuals and corporations during the day. Conversely, if it is expensive to borrow to make up a shortfall, banks are going to be very careful about lending during the day to make sure their reserves are over 10%. This applies significant pressure on the rates for loans that the bank offers; if the Federal Funds rate goes down, all else being equal, the interest rate on loans from banks will also go down.
These actions have a tremendous effect on the interest rates on car loans and mortgages. But looking at recent history, the Fed did not raise its target for the Federal Funds rate from essentially zero from 2008 until 2015. Does this mean that loans were interest-free during that time?
If only we were so lucky! Though the discount rate puts significant pressure on the interest rates for personal loans, it is not the only factor. In fact, when a bank is making a loan, it is essentially making an investment in debt. As such, your debt needs to be competitive with other debt instruments available on the free market. And who is the most ubiquitous debtor in the world? The U.S. Government, of course!
Your mortgage is actually competing on the open market most closely with U.S. Treasury bonds that mature in 10 years. As the yield on these bonds rises and falls, so will the rate that you are offered for a mortgage. Certainly, the rates on Treasuries is affected by the Fed (particularly during the Treasury-purchase program known as Quantitative Easing that was just recently ended), but many other factors come into play as well. An increase in demand for bonds, for instance from a tanking stock market, would increase the prices of these bonds, causing the yields to go down. As these rates rise and fall, so will the rate on personal loans.
So why is the Fed involved in loaning money to banks at all? What are its aims and how successful has it been in the past at achieving its goals? I could discuss this or a thousand other relevant issues, but digging deeper into the Fed can often result in more confusion. Since Mark Wahlberg is a busy man, I want to respect his time and keep this post short and readable.
The Fed is complicated and very frequently misunderstood, but its influence on the business cycle and global economy cannot be understated. Though it may require an economics PhD to fully understand it, knowing its functions at a basic level is relevant to every person working in business today...even Hollywood actors.
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