Federal Funds Rate
The federal funds rate is an interest rate at which depository institutions lend balances (funds maintained at the Federal Reserve) to each other overnight. When one bank has surplus balances in its reserve account, it lends to other banks in need of larger balances. In simpler terms, a bank with excess cash, which is often referred to as liquidity, will lend to another bank that needs to quickly raise liquidity.
The federal funds rate is an important benchmark in financial markets, since it determines the costs of borrowing reserves for commercial banks. An increase in the federal funds rate discourages banks from taking out inter-bank loans, which in turn hampers the credit expansion. Conversely, a decrease in the federal funds rate encourages banks to borrow money and expand credit for entrepreneurs and consumers.
Thus, the federal funds rate is the central interest rate in the U.S. financial market. It influences other interest rates such as the prime rate, which is the rate banks charge their customers with higher credit ratings. Additionally, the federal funds rate indirectly (via the arbitrage process) influences long-term interest rates on mortgages, loans, and savings.
Federal Funds Rate, Effective Federal Funds Rate and Federal Funds Target Rate
The federal funds rate should not be confused with the effective federal funds rate and the federal funds target rate. The former is a weighted average of the federal funds rate across all transactions in the inter-banking market. The latter is determined by the Federal Open Market Committee which meets eight times a year. The Federal Reserve influences the federal funds rate through open market operations to reach the federal funds rate target. When it believes that inflation is too high, it raises its target rate and decreases liquidity by selling government bonds, thereby raising the federal funds rate because banks have less liquidity to trade with other banks. Conversely, when the Fed believes that inflation is too low or unemployment is too high it lowers its target rate and increases liquidity by buying government bonds, decreasing the federal funds rate because banks have excess liquidity to trade.
Federal Funds Rate and Gold
Many investors believe that the federal funds rate is adversely related to the gold price. Interest rate cuts are perceived as a sign of a cheap money policy – a bullish signal in the gold market. Similarly, the rise of the federal funds rate is considered as detrimental for gold prices. However, this assumed relationship does not always hold. As one can see in the chart below, there is no strict correlation between the federal funds rate and the price of gold, and there were many cases when the tightening cycle was accompanied by upwards moves in the price of gold.
Chart 1: The effective federal funds rate (green line, left axis, in percent) and the price of gold (yellow line, right scale, London P.M. fixing) from 1968 to 2015.
The best example may be the second half of the 1970s. The federal funds rate soared from 1977, peaking at more than 20 percent in 1980, and gold reached a peak of $850 per ounce in the same period. Though nominal interest rates soared, real interest rates remained negative (because of the stronger rise in the inflation rate), causing the rise in gold prices. Therefore, real interest rates are much more important for the price of gold than the federal funds rate.
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