One Rate to Rule Them All

Money and the federal funds rate [1]

We have all the pieces of our inflation puzzle in place.

Let’s go back a step and remind ourselves that too much money chasing too few goods causes inflation. We also know that that means demand went up, while supply fell. The Federal Reserve Bank (the Fed) wants to decrease borrowing to cool demand.

On the March 29th podcast of Marketplace, Fed Chairman Jerome Powell said that the supply had healed. “Workers came back into the labor force [and] the supply chain healed in 2023.”

The Fed influences “the interest rate” that banks use as part of their strategy for loaning money. If we can get banks to make fewer loans, the rate of growth of the money supply will fall. Because we also now know that when banks create loans out of excess reserves, they create money. The reverse is also true.

We learned in the last post that banks create the money supply. Banks can also shrink it. [2]

The role of excess reserves

If we want to change the money supply, we need to change the amount of money banks have available to make loans. That leads us to more questions: How do we change the dollar amount of excess reserves that banks use to make loans?

Sometimes a bank will find they have excess reserves that they want to keep available for future loans. But if they hold onto excess reserves, they’re losing out on an opportunity to make profits. Their investors want higher profits, while their customers want to make sure their deposits are safe.

The best way to deal with those excess reserves, then, is to loan them out overnight. The rate they can get is the “cost” of loaning money. There is a market for these funds, because sometimes a bank won’t have enough “on reserve” to cover their deposits. We know that government mandates that banks have enough available on reserve.

During periods when the the economy is doing well and/or the rate that banks can borrow money overnight is low, some banks may make a habit of borrowing in the overnight market. If inflation is higher than acceptable, the Fed wants to raise that rate to get banks to loan out less. What is that interest rate?

That one rate

In the US, one interest rate influences mortgage, car and business loans, and credit card rates. It is the federal funds rate. The federal funds rate is the rate banks charge each other to borrow money in the overnight market.

We also know that there is more than one interest rate. Interest rates on home loans (mortgages) are lower than they are on car loans, which are lower than the rates on credit cards. Why?  

Banks take in money in the form of deposits and use a proportion of that money to make loans. They can store it in the vault as currency or in an account, usually in an account at the Federal Reserve. [2] Keeping that amount at the Fed is called “on reserve.” They can also store the deposits in other less liquid assets.

Banks create loans to make profits. They also create “money.”

What is money?

According to Irena Asmundson and Ceyda Oner in a publication for the IMF, “money is anything that holds its value, can be easily translated into prices, and is widely accepted.” In the US, it’s US dollars.

Except during periods of high inflation, the aftermaths of WWI, WWII, the oil crisis, and the COVID pandemic, the US dollar has held its value well, compared to most other countries. [4] We know what a price of anything priced in dollars, say $26.49, means.

And everyplace you go inside the US and its territories will accept dollars. The US dollar meets the criteria for “money.” The idea is so prevalent in the US, and elsewhere, that there are a number of slang terms for it, such as mullah, dough, loot, and even, the word money as used for income, assets, or profits.

The narrowest definition of money in the US is called M1. M1 is also the definition of the money supply. If we can shrink the money supply, then we can shrink inflation. The latest inflation news shows that this is happening. [5]

M1 includes cash and checking account deposits. Federal law requires banks to keep a certain proportion of your money on hand in cash and checking. As we learned last time, banks use the reserves left over (excess reserves) to make (or create) loans. Those loans are for cars, homes, and businesses. The rates banks charge on those loans depends on the federal funds rate, the cost of borrowing for banks.

The rates banks charge also depend on the riskiness of the asset and the ability of the person getting the loan to pay it back. Credit card debt is unsecured, so it is the riskiest, car loans less so, and home loans are the least risky. If your income is higher or you have other assets, that can also affect the rate you’re offered.

These loans are part of a bank's assets. Banks also hold onto other assets, such as bonds. Next week, we’ll look at bonds and bond prices and finish our Crash Course on inflation. In the last post in our Crash Course on Inflation, we’ll look at what’s happened in the economy as a result. Future posts will look at the overall economy in more depth.

Thanks for taking the time to read. I value your comments and questions.

Nikki

[1] This idea is not new. It used to apply to the LIBOR rate and still applies to the Thomson scattering rate in astrophysics. Most recently it’s been used to describe the federal funds rate.

[2] Technically, the rate of growth of the money supply.

[3] The National Credit Union Association (NCUA) regulates and insures credit unions.

[4] I have a Zimbabwean $10 trillion dollar note on my desk to show how printing money without incurring debt leads to hyperinflation and a currency with no value.

[5] For July 2024, the CPI dropped to 2.9 percent and the PCE to 2.5 percent.