What is Quantitative Easing?

Quantitative easing, known as QE, is a monetary policy used by a central bank to increase the money supply by increasing the excess reserves. In layman’s terms, they inject a lot of new money into the money supply through open market operations. If this sounds like the central bank is just printing more money, you’re right (technically they just make up money out of thin air electronically, no actual printing is necessary). The specifics of how they do this are probably not important to 99.99% of us, but they’re explained below, but what is important is why a central bank like the Federal Reserve would want to do this.

How is QE accomplished?

(in case you were curious) The central bank essentially credits its own account with new money and uses that money to buy assets from banks, thus increasing the reserves at those banks. Those banks can then lend that money out at a multiple based on the reserve ratio. If the ratio is 10%, then they can lend out 90% of the amount of the added reserves. Reserve ratios are the percentage of an asset they must keep as reserves (so if you have $100 and the ratio is 10%, you can lend out $90). The next bank can lend out $81, keeping $9, and so on and so forth.

(Click to continue reading…)


Fed Says Recession “Likely” Over, Experts Don’t Believe It

Grays Papaya Recession SpecialOn Wednesday, the Federal Reserve will conclude its two day FOMC meeting and announce what they plan to do with the federal interest rate. Most experts expect the rate to stay at the 0% to 0.25% range the Fed set several months ago. With unemployment near or above double digits in some areas, it would be extremely difficult for the Fed to justify a rate increase at this point.

Last week, Jim asked if you thought the recession was over. In the post, he highlighted Ben Bernanke’s comments about how we were “very likely” seeing the end of the Recession but it doesn’t appear that experts believe him!

In general, the Federal Reserve lowers the target rate when it wants to boost the economy. Lower rates mean businesses can borrow money cheaper. It also means banks offer lower rates on deposit accounts, like CDs and savings accounts. The lower they go, the less incentive we have to save – so we boost the economy be spending more. The 0% – 0.25% target range is about as low as it can go.

We need to wait until Wednesday to see what the Fed announces but experts believe rates won’t increase until next year. If you were hoping for a frothy return to economic prosperity… you might have to wait until next year to pop the bubbly.

Fed not acting like there’s a recovery [CNN Money]


Predicting Federal Reserve Rate Changes

Do you ever read the news or watch television and wonder what those speakers mean when they say “the market predicts the Fed will [increase rates/cut rates/do nothing]?” I have.

What they are referring to is the federal funds futures market where traders buy and sell options contracts linked to the federal funds rate. Unlike other options, where an actual asset could be delivered (an oil futures contract is actually a contract to buy or sell oil at a future date), the federal funds futures contract is a little different. Rather than butcher the definition, according to the Federal Reserve Bank of Cleveland:

A fed funds futures contract is an interest rate futures; i.e. a futures contract whose value is based on a fixed-income security or interest rate. The underlying interest rate for the fed funds futures contract is the average daily effective federal funds rate for the delivery month. The final settlement price for a contract is 100 minus this average rate.

When the market “predicts” the next Fed action, it’s really what the wisdom of the masses (the fed futures trading masses) believe, based on their trading actions, what the future federal funds rate will be in the delivery month of the option.

Where can you find this information easily? The Federal Reserve Bank of Cleveland’s Fed Funds Rate Predictions page! It’s updated daily and has tons of information (check out the excel spreadsheet you can download).

How can you use this? Outside of fun trivia, one way to take advantage of this is to avoid buying long term CDs if the prediction says the rates will go up and to buy CDs when the rates are going down. While the predictive ability spans only a few meetings in the future, it can give you a better idea if you’re deciding what to do. Of course, since everything is measured in probabilities, anything can happen.

 Banking, Personal Finance 

Remember Certificates of Deposit During Fed Rate Cuts

If you think interest rates are falling, put some of your savings into a CD. Since last August (2007), the Federal Reserve, haunted by the spectre of a slowing economy, had been hacking and slashing the Federal Funds and Discount rates. During that run, and until just recently, the prevailing attitude on Wall Street was that the Fed was going to continue cutting the rate until the threat of future inflation balanced out the threat of a recession. With this last twenty five basis point cut at the end of April, the prevailing attitude changed. Analysts now believe the Fed will stand pat and potentially even raise rates in the future.

During those rate cuts, all of the high interest online banks dropped their savings account interest rates dramatically. Since January of this year, the interest rate on E*Trade’s online savings account fell from 4.95% to 3.01% (only to increase, just recently, to 3.15%). ING Direct account holders saw their rates fall from 4.10% to their current rate of 3.00%. If you were able to purchase a CD at the prevailing higher yield online savings account rates for even a year, you’d be sitting pretty on those funds right now and that’s why CDs become popular during a falling interest rate environment.

This is where you say: “Jim, I’m not an idiot, I know that if the rates are going lower then I want to lock in good rates.” Yes, you are not an idiot but the point is I didn’t lock in any funds in CDs, except for my laddered emergency fund, because I didn’t recognize that I should have (or at least should have considered it). It wasn’t an error of judgment but one of ignorance.

Everyone knew rates were going to be cut but not everyone realized they should’ve considered putting a little bit away in certificates of deposit. (I can confidently say that because I know I didn’t) So, the next time you think rates are going to stagnate or fall, lock a little away in CDs.

 Personal Finance 

All About Rates: Fed Rate, Prime Rate, LIBOR and COFI

The Fed did what everyone expected this past week, cutting the federal funds rate by 75 basis points to 2.25%, a little less than what the market wanted (they wanted a full 100 basis point cut down to 2%). The federal funds rate has gotten a lot of press lately and many people have started to understand how the Fed Rate personally affects them. Some have been confused between the federal funds rate and the federal discount rate, which I tried to explain in the past, and wanted to learn why the fed rate affected the stock market, but overall I think it’s relatively well understood. The other popular rates that aren’t as well understood are the Prime Rate, the London Interbank Offered Rate (LIBOR), and the 11th District Cost of Funds Index (COFI).

Prime Rate

What is it? The prime rate is a generic term but in the US it primarily refers to the the Wall Street Journal Prime Rate. It is “the base rate on corporate loans posted by at least 75% of the nation’s 30 largest banks.” [Source: Wikipedia] Usually you can expect the rate to be about 3% higher than the Federal Funds rate so when the Fed drops its rates, you can expect the Prime Rate to fall as well (but not always). WSJ prints this rate about once a month.
Why does it matter? The Prime Rate is often the rate you see associated with credit cards, car notes, and all other types of consumer debt. For example, a card may have their variable purchase and balance transfer APR pegged to the Prime Rate plus 4.99%, so that rate will be the Federal Funds rate plus around 8.99%. Since the Fed cut the rate by 75 basis points, you should expect a similar fall in your interest rates. The Prime Rate is published by WSJ so it will lag the Fed by a little bit, so you might not see the lower rate for a little while.

London Interbank Offered Rate (LIBOR)

What is it? The LIBOR is “a daily reference rate based on the interest rates at which banks offer to lend unsecured funds to other banks in the London wholesale money market (or interbank market).” [Source: Wikipedia] In other words, it’s the Fed funds rate in London. Some other notable differences are that it’s a daily rate, announced after 11 AM by the British Bankers Association, and is an average of rates on inter-bank loans of up to 1 year with contributor banks. It’s a lot like taking a snapshot of the crowd at a sporting event, you get close but it’s obviously a continually moving target. Another difference between the two rates is that with the Fed funds rate you’re talking about the target that the Fed is trying to hit by adding liquidity. With the LIBOR, it’s the actual rate being charged and not a target. While it is an academic difference, it’s a difference nonetheless.
Why does it matter? Some adjustable rate mortgages are actually linked to the LIBOR, such as LIBOR + 2.75% or LIBOR + 2.0%; so when the LIBOR moves around, it can affect what your ARM is adjusted to.

11th District Cost of Funds Index (COFI)

What is it? Last but not least, we have the 11th District Cost of Funds Index (COFI), an index I never heard of before researching this article. The COFI is a little more complicated and is “computed from the actual interest expenses reported for a given month by the Arizona, California, and Nevada savings institution members of the Federal Home Loan Bank of San Francisco (Bank) that satisfy the Bank’s criteria for inclusion in the COFI (COFI Reporting Members).” [Source: FHLBank San Francisco] Like the Prime Rate, this rate is reported on a monthly basis but two months behind (so the January value is reported in March).
Why does it matter? Again, it’s an index used to adjust mortgages and other loans and it’s popular because it lags the market and is a stable measure. This means that it’s good when the rates are increasing, since it lags, but not as good when the rates are falling, since it lags. The reason why its stable is because it includes more factors such as loans from savings and checking accounts, CDs, etc.

Hope that clarifies things just a little bit more…


Why Fed Rates Affect Inflation

When the Fed drops its federal funds rate, economists across the world shudder as they see the spectre of inflation peer over the horizon. You ever wonder why that is? The answer is quite simple but will come in two parts. First, a brief refresher on supply and demand, followed by how that and the Fed’s lowering of rates may bring on inflation. Before we begin, I want to make note that everything has been simplified from what’s actually going on. Everything is very complicated in reality but you can explain the gist fairly easily if you’re willing to take some liberties. Those who have a background in economics and know all the intricacies will see some inaccuracies, but they are there to make the explanation smoother. A basic understanding is far better than none at all.

Supply & Demand 101

Simplistically, economists believe that supply and demand will dictate price. If you have more supply with the same demand (surplus), the price goes down. If you have less supply with the same demand (scarcity), the price goes up. If demand goes up with the same supply, price goes up, and vice versa. You’ll see this represented with supply and demand “curves” with the price at where the two intersect. There’s far more to it than that but that’s enough to go on. (it’s actually quite cool if you’re interested, google up some more info)

Fed Target Rate

When mainstream media folks talk about the Fed lowering the federal funds rate, what they’re really talking about is the Fed lower its target rate. The Fed is like a puppet-master and the banks are its puppets. When the Fed says it wants to lower the target rate, it’s really saying that it’s going to be putting more money into the market to lower the cost of it. It’s like a puppetmaster putting on a good show, a twist of a finger here, a lift of the wrist there, and before you know it you have yourself a Broadway musical. The Fed’s “twist of a finger” is sending additional funds to banks that may be low on reserves.


Ideally, the target rate drives the Fed to only put as much additional funding as is needed to keep the economy humming along and banks able to fund their work. Unfortunately, there’s a lag between when the Fed begins acting and when the effects take hold. The fear of inflation is founded in the fact that if the rate is set too low and too much additional funding is pumped into the system, banks find themselves with more than they need.

What happens if they have more money than they need? They lend it out at cheaper prices! (more supply than demand) When consumers get more money, they will spend more money. When they spend more money, demand on goods and services will go up. As demand increases, sellers of products and providers of services will increase their rates… which is inflation.

Inflation is not bad. Moderate inflation is normal and expected. It’s a sign that goods and services are in demand, consumers are financially strong enough to support increased prices, and a signal that the economy is strong.

High inflation is bad. It’s bad because it hinders economic growth. When inflation is high, investors will demand higher rates of return for their savings and so borrowers of money, business and such, will have to pay more to borrow money. If they pay more, the pace of growth slows down. The economy slows down, inflation will settle, and we continue the cycle all over again.

That’s (simplistically) why the Fed lowering rates can lead to high inflation.


Federal Funds Rate vs. Federal Discount Rate

The federal funds rate is the interest rate that banks charge other banks when lending money to them. One of the consequences of having a reserve limit is that sometimes banks, in trying to stay as close to that limit as possible, may go under it and thus need to borrow some money to boost their reserves. This rate is set by the Federal reserve.

The federal discount rate is the interest rate that the Fed charges banks when it lends the bank money. This amount is higher than the Federal Funds Rate so it’s used as a last resort for banks needing some cash to boost their reserves.

In an earlier article on how the Fed rate affects the stock market, I made an error of omission by mentioning only the federal discount rate and wanted to take the opportunity to clear that up.


Why The Fed Interest Rate Affects The Stock Market

In layman’s terms, which is what the title was put in, the reason why the interest rate, dictated by the Fed, affects the stock market is because it affects the interest rate on loans that businesses can get to grow their businesses. When the interest rate goes up, loan rates go out and businesses have to pay more on their loans and thus have less to put back into the business. The interest rate also affects consumers because the rates on their loans are going to go up and thus their ability to spend money is going to go down. If consumers are spending less, businesses are making less; yet another hit to the future growth potential. Since the stock market is supposed to track the business, rate hikes affect growth projections and thus the price of the stock. The price of a stock is based on those projections, so increased costs (rate hike) means potentially decreased future growth, and so the price goes down. Rate hike means stocks weaken, rate drop means stocks strengthen. That’s the layman’s version and that’s basically like explaining the waves at the top of the ocean without looking at the multitude of forces at play below the surface.

The Fed

In actuality, when people say “the Fed,” short for Federal Reserve, they actually mean the Federal Open Market Committee. The committee consists of the Board of Governors of the Federal Reserve System, the President of the Federal Reserve Bank of New York, and four of the eleven remaining Federal Reserve Banks on a rotating basis. The FOMC meets eight times a year and Ben Bernanke is the Chairman of the Board of Governors. The Board of Governors is in charge of setting the discount rate (what people commonly call the “interest rate”) and the reserve requirement.

The discount rate is what the Federal Reserve will charge banks to borrow money from them. The reserve requirement is how much, percentage-wise, a bank must hold in its reserves to cover deposit requirements. This idea kind of blew my mind when I first heard about it like ten years ago. So when you deposit $100 at the bank, if the reserve requirement is 10%, then the bank must keep $10 on hand but it can lend out the $90. Let’s say they lend that $90 to another bank. The second bank must keep $9 in reserves but it can lend out the $81. This can happen, in theory, forever and so the original $100 actually ends up becoming really really close to $1000 in total value across however many instruments when it’s all said and done.

The Discount Rate

So, how does the discount rate affect the interest rate? Well, as mentioned earlier, the discount rate is the rate at which commercial banks can borrow money from the Federal Reserve. If the rate increases, then the cost to banks increases and that cost is passed onto its borrowers. Then the borrowers, who are themselves consumers of the products and services of businesses, will be spending less in stores and thus reducing the revenue stream of the businesses they frequent. Businesses are hit with a double whammy – if they need loans, those are more expensive; plus their customers are spending less. Businesses that are earning less, hire less people, those people who are thus not hired will find themselves spending less… and so you can see how the cycle can feed itself. The public barometer that the Fed uses to see how well this cycle is operating is inflation. The hard part about dealing with inflation is that interest rate changes are the cause but the effects aren’t seen for years, so it’s a difficult game to be playing.

Update: In addition to the discount rate, the Fed also sets the federal funds rate but it generally moves lockstep with the discount rate. For a discussion on the difference, please refer to this article on the differences between the discount rate and the Federal funds rate.

As you can see, the basics are pretty easy to understand: rates go up, market goes down; rates go down, market goes up (in general). However, there are so many factors at play in there that to boil it down to that one liner doesn’t do it any justice.

Advertising Disclosure: Bargaineering may be compensated in exchange for featured placement of certain sponsored products and services, or your clicking on links posted on this website.
About | Contact Me | Privacy Policy/Your California Privacy Rights | Terms of Use | Press
Copyright © 2016 by All rights reserved.