Federal Funds
Let's start with the meaning of the term, Federal Funds which are the reserve balances at the Federal Reserve Banks that Depository Institutions lend to one another.
A Depository Institution is a Financial Institution that obtains its fund from the public deposit. The examples of Depository Institutions are the commercial banks, savings banks etc.
The Federal Fund deposits while lying with the Federal Reserve Bank do not bear any interest, but they can be lent to other banks requiring it at the federal fund rate. Thus, the Federal Funds transactions allow the depository institutions to utilize the funds which are otherwise lying idle with the Federal Bank as reserves.
Meaning of Federal Funds Rate:-
The Federal Funds Rate is the interest rate at which one depository institution lends the federal funds (in excess of the reserve requirement) to another depository institution.
When the monetary policy is formulated a federal funds rate is fixed by the Federal Reserve Bank.
Mechanism of Federal Funds:-
The banks need to keep some reserves at the Federal Reserve Bank to meet there reserve requirements and these reserves are known as Federal Funds. Now, the Depository Institution can lend these funds to one another. During a federal funds transaction the depository institution having reserves in excess of the reserve requirement can lend the funds to the depository institution having a reserve deficit.
Thus, in the federal funds transaction the total reserve of the federal bank is not affected, it just redistributes the reserves and by doing so the funds lying as reserves yields a good return.
Depository Institutions participating in a federal fund transaction are the commercial banks, agencies and branches of foreign banks in the United States, federal agencies, and government securities dealers.
There are certain Financial Institutions which acts as intermediaries as several Brokerage
Firms. They neither lend nor borrow the funds they just guide the funds from one
Depository institution to another and during the process they earn commission.
The Federal Funds Transaction:-
The transaction can be initiated by either a federal fund borrower or a federal fund lender.
If a depository institution desires to lend the Federal Funds it needs to find a borrower for the same. Finding a borrower can be done directly through the existing relationships of the bank or indirectly through a brokerage firm.
When the funds are to be transferred the lending bank authorizes the Federal
Reserve Bank to debit its reserve account and credit the reserve bank account of the borrower.
Coming to the different types of federal funds transaction there may be transactions which are short term unsecured loans and there may be others which have long term maturities.
The short term unsecured loans are the most common type of federal fund transaction.
Most of these transactions are without a contract and are based upon verbal agreement. The credit limits are recognized so that the lender is exposed to minimum risk.
The Overnight federal fund transactions are under a continued contract and the contract is automatically renewed unless it is terminated either by the lender or the borrower.
The Role of Federal Funds in the Monetary Policy:-
Before understanding the correlation between the monetary policy and Federal Funds lets understand the existence of Fed or Federal Reserve.
The Federal Reserve is an independent identity that governs the economic and monetary policies of United States. It is the bank of US government and regulates the various financial institutions of the country.
So it may be Alan Greenspan or Ben Bernanke, Federal Reserve always plays an important role in formulating the monetary policy of the country.
There are 12 Regional Federal Reserve Banks located in major cities of the country.
There is another organization within the system known as Federal Open Market Committee (FOMC) which basically formulates the monetary policy.
The Federal Open Market Committee set a target for the federal funds rate though the actual rate is decided by the open market.
All the banks require to maintain a reserve with the Federal Reserve Bank and while carrying out day to day business they repeatedly fall below the requirements and to meet this they have to borrow the reserve from some other bank who lends the reserve to the former. This forms a foundation of a federal fund transaction in a federal fund market, where there is borrowing and lending of the reserves at the federal funds rate.
The depository institutions are usually required to maintain around 10% of the deposits held by the bank as reserves with the Federal Reserve Bank.
The Federal Funds rate has its own importance as variation in this rate can affect every other interest rate charged by the U.S. banks and the federal funds rate is influenced by the Federal Reserve Bank.
The Federal Reserve Bank buy and sell the U.S. government securities in the financial market (these are called as federal reserve open market operations) and these open market operations have an effect on the level of reserves in the banking system. Now by these operations, the Federal Reserve Bank can influence the federal funds rate.
For example, when the federal bank desires to decrease the Federal Funds rate it starts purchasing the government securities while carrying out the open market operations and by doing this there are excess bank reserve. Due to increase in the availability of the reserve there is a downward pressure on the federal funds rate.
And similarly, when the federal bank desires to increase the federal funds rate it sells the government securities in the open market due to which there is a lack of bank reserves which in turn put an upward pressure on the Federal Funds rate.
The federal funds rate has implication on all the loans and investment decisions by the depository institutions for example, the decision of loans to the businesses and foreign institutions by the commercial banks is affected by the federal funds rate.
Thus, the federal funds and monetary policy are correlated and the formulation of the monetary policy has an impact on the federal funds and the federal funds rate.
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