Tuesday, July 21, 2009

the federal funds rate

The federal fund is the rate at which depository institutions borrow and lend reserve in the federal fund market, the market for inter bank lending. In fact, there is no signal "federal funds rate"; the federal funds rate reported daily in the wall street Journal and other news sources really is an average of rates across institutions. Different depository institutions typically pay different rates to borrow or lend federal funds, a phenomenon known as tiering of the federal funds rate.
This tiering results, in part, from the fact that the federal funds market is somewhat segmented. That is, there are different parts of federal funds market that are interlinked but function differently, leading to differentials between the federal funds rates paid by different financial institutions. A large segment of market transactions on any given day are "brokered" trades in which depository institutions make bids to buy or sell funds through intermediating federal funds brokers who process information and assist in matching borrowers and lenders of federal funds.
Another segment of the federal funds market is dominated by large depository institutions that function as major dealers of federal funds. These dealers stand ready both to borrow from and to lend to other depository institutions that are said to constitute the retail portion of this segment of the market. These dealing banks then profit from differentials between the rates at which they lend and borrow federal funds.
Another reason for tiering in the federal funds rate is that some depository institutions are regarded as better risks than others. Those that are widely regarded poorer risks often must pay a risk premium to borrow federal funds. This means that they must pay a higher interest rate than those depository institutions that lenders believe are much safer borrowers.
The federal funds rate is important not only to the depository institutions that trade federal funds. It also has been an important variable in the conduct of monetary policy. Indeed, at various times it has represented the most important gauge of the intent of monetary policy actions by the Federal Reserve System.
An interesting development in recent years has been the very gradual unfolding of an intraday federal funds market- a market for federal funds loans with maturities of a few hours during the day. There are two key reasons that depository institutions have begun to make such trades. One is that computer and communications technology of modern payments systems has made such exchanges easier and safer to conduct. The second is that, for a variety of reasons, some depository institutions are finding that funds of such short maturities have intraday value for which they are willing to pay interest.

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