“The Fed just dropped interest rates by a quarter of a point!” screamed the headlines. What does that mean and why does it get so much attention?
The talking heads, the editorial writers, and the financial commentators all discuss reasons—inflation not meeting targets, the economy is slowing and needs a boost—the various reasons given by the pundits and the Federal Reserve Chair himself, but they don’t explain how the quarter of a point move has any impact on you. This blog will try to shed a little light.
First, we must define the federal funds rate. According to Wikipedia, “In the United States, the federal funds rate is the interest rate at which depository institutions (banks and credit unions) lend reserve balances to other depository institutions overnight, on an uncollateralized basis. Reserve balances are amounts held at the Federal Reserve to maintain depository institutions' reserve requirements. Institutions with surplus balances in their accounts lend those balances to institutions in need of larger balances.”
Although these rates are negotiated between banks, the Feds have tools to affect the rates. This is the only rate the Feds can control. All other interest rates are determined by auctions or free market activities.
On July 31, 2019, when the Fed dropped interest rates by a quarter of a point, the Treasury's 10-year note was paying 2.05% (a rate set by the free market). Many believe this rate is heading lower in the coming months, irrespective of the Federal Reserve. The Fed Funds rate, by contrast was paying approximately 2.4%. In fact, Treasury bonds that have about 20 years to go before maturity, are paying a nominal 2.5%. So what does this mean? I’ll try to put into perspective for you.
Imagine going into a bank and asking what the CD rates are. The teller responds as follows: “If you put your money in a savings account with no time limit as to when you can take your money out, we’ll pay you 2.4%. If you buy a 10-year CD, where there might be a penalty for early withdrawal, we are paying 2.05%.”
You would probably say, “Why should I tie up my money for 10 years at a lower interest rate?” It doesn’t make sense at your local bank and it certainly doesn’t make sense for monetary policy in normal times.
By dropping the interest rate by a quarter of a point, the Fed Funds rate is now about equal to the 10-year rate. That still doesn’t make sense, so I believe the Feds will have to drop the overnight Fed Funds rate another quarter of a point.
If the 10-year yield should drop to 1.75%, a second or third rate drop should occur to keep consistent with what we all know intuitively—money tied up for a long time should pay a higher rate than money tied up a short time.
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