Tag Archives | federal funds rate

London Interbank Offered Rate (Libor) Controversy

London Interbank Offered Rate (Libor) Controversy (June 2008)

Presently, there are two issues regarding the London Interbank Offered Rate (LIBOR). First, dollar Libor quotes are considered too high compared to the federal funds rate. Second, elevated Libor quotes are considered too low compared to other market-based interest rates.

British Bankers’ Association (BBA) Reaction (bba.org.uk)

The British Bankers’ Association (BBA) reviewed the situation and decided to alter the process for setting Libor. Possibly by fall 2008, the British Bankers’ Association will increase the number of banks that contribute the rates that comprise the London interbank rates. Using more contributor banks would give a more accurate average rate. Also, the British Bankers’ Association plans to increase the scrutiny of the contributed rates to ensure their validity. Changing Libor bank rates in any way is a challenge, legally and financially. Hundreds of trillions of dollars in financial contracts around the world depend on the Libor benchmark.

Libor Federal Funds Spread

Regarding the first issue, the federal funds rate is currently at 2% and the short-term dollar Libor rate is significantly higher. Actual Libor bank rates fluctuate and differ by maturity, but the overnight dollar Libor rate was recently at 2.48%. US banks can raise dollar funds from the US Federal Reserve. European banks cannot. This implies that US banks can raise dollar funds more cheaply than European banks. Dollar Libor is calculated using rates contributed by 3 US banks and 13 European banks. Because there are more European contributor banks than US contributor banks, the dollar Libor rates are skewed to the higher European rates. The BBA is considering publishing a separate index to represent dollar Libor quotes for European banks.

Validity of Libor

Recent rises in Libor lagged behind rises in other market-based interest rates. This raised suspicion regarding the validity of Libor. Some suspect contributor panel banks were underreporting their borrowing costs to avoid looking desperate for cash.

Contributor panel banks submit borrowing rates to the BBA each weekday. Some analysts suspect that contributor banks are submitting rates lower than the true borrowing rates. Banks may be reluctant to reveal that they are paying higher borrowing rates, which might indicate less creditworthiness. Lower than expected Libor rates could be evidence that some banks are submitting lower than actual borrowing rates. The financial markets expect the US Federal Reserve to raise its key interest rate later this year. This is influencing rises in short-term treasury yields and money market borrowing rates. In this environment, Libor rates have not gone up as much as expected.

Today’s Libor Index

For the dollar Libor rate today and other Libor current rates, go to: bankrate.com.

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london interbank offered rate (libor)

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london interbank offered rate (libor)

See Also:
LIBOR
Libor versus Prime Rate
Annual Percentage Rate
Required Rate of Return
What are the ‘Twin Deficits’?

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Federal Funds Rate Definition

See Also:
Interest Rate Swaps
LIBOR
Interest Rate Definition
Interest Rate Risk
Prime Lending Rate
Libor versus Prime Rate
Interest Rate in Selecting Loan

Federal Funds Rate Definition

The federal funds rate definition, or fed funds rate, is the target interest rate for overnight lending and borrowing transactions between banks. The Federals Open-Market Committee (FOMC) sets the US fed funds rate. FOMC is a committee within the central bank of the United States. (For current and historic fed funds rates see the links below).

The fed funds rate is a macroeconomic indicator, closely watched by economists. It is also a central bank monetary policy tool used to influence the nation’s money supply. Use the rate as a reference rate for the US Prime Rate.

Commercial banks and other depository institutions maintain required reserves of capital at district Federal Reserve banks. Furthermore, the fed funds rate technically refers to the rate at which these institutions lend their Federal Reserve account balances to other institutions for short-term or overnight loans.

Federal Reserve Interest Rate Changes

The FOMC meets eight times per year – approximately every six weeks. At these meetings the committee discusses, among other things, the possibility of changing the fed funds rate. Additionally, the actual market rates may differ from the fed funds target rate. However, the target rate is set with the expectation that market rates will conform to the target rate.

The FOMC can lower the fed funds rate. This is typically done to stimulate the economy. The idea is that lower interest rates will encourage lending and borrowing and stimulate economic activity. Increased lending and borrowing also increases the nation’s money supply. Thus, an increased money supply can spur inflation.

The FOMC can increase the fed funds rate. They do this to reduce inflation or slow transactions growth. The idea is that higher interest rates will discourage lending and borrowing transactions. Less lending and borrowing can dampen economic growth. Therefore, this will reduce the money supply and reduce inflation.

Federal Open Market Committee

The Federal Open-Market Committee is a committee within the US Federal Reserve System, the US central bank. This committee is responsible for, among other things, setting the federal funds target rate.

Federal Funds Rate – Prime Rate

Use the fed funds rate as a reference for setting the US Prime Rate. The US Prime Rate is typically set at 300 basis points (or three percentage points) above the fed funds rate. For instance, if the fed funds rate is 2%, then the Prime Rate would be 5%.

Current Fed Funds Rate

To see the current and recent fed funds target interest rates, to go: www.bankrate.com.

Historic Fed Funds Rate

To see historic fed funds target interest rates, to go: www.newyorkfed.org.

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federal funds rate definition

federal funds rate definition

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Basis Points

See Also:
Accounts Payable
Margin vs Markup
Collateralized Debt Obligations
Are You Collecting Business Data?
Benchmarking

A basis point is one hundredth of a percentage point. A single basis point would look like this: 0.01%. Fifty basis points is a half a percentage point: 0.50%. 100 basis points equal one percentage point: 1.00%.

When To Use Basis Points

In finance, changes in the values of financial instruments or interest rates may be denoted in basis point. They are used to describe quantities less than one percent. When the Federal Reserve lowers its fed funds rate by a half a percent, the media may report that the fed funds rate was lowered by 50 basis points.

Similarly, the interest rate on a loan or debt instrument that is based on a reference rate, such as LIBOR or the Prime Rate, may have a spread quoted using the term basis point. The rate may be described as Prime Rate plus 50 basis point. If Prime Rate is 5%, then the rate on that loan or debt instrument would be 5.5%.

basis points

 

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What Will the Fed Do?

The Federal Open Market Committee is expected to announce a third consecutive cut in the federal funds rate today. Equities were up early, but have fallen to near their open in advance of the announcement which will come later today. What will the Fed do?

What Will the Fed Do?

It would seem that the Fed is anticipating a slowdown in economic growth. The global economy is working through the problems in the credit markets. Furthermore, the meltdown in securities backed by subprime and adjustable-rate mortgages (ARMs) creates these problems. In addition, the anticipated impact of expected significant declines in home prices (US and UK) created these problems.

What Will the Fed Do

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Fed Lowers Rate Target – Time to Pop the Cork?

Yesterday afternoon, the Federal Open Market Committee did what nobody expected. The Fed lowers rate target. If you paid any attention to published reports, then they acknowledged what was already priced in by the futures markets and lowered its target for the federal funds rate by 50 basis points to 4.75%. While US equity markets reacted favorably to the news, with the Dow Jones Industrial Average, Nasdaq Composite, and S&P 500 indices all up on the news today, it is unclear as to whether this is a sign of good things to come, as the equity market reaction seems to suggest, or merely an attempt to forestall an inevitable slowdown of the US economy. The Fed, for its part, couched its change as a response to the current troubles. They have hit the credit markets, in particular mortgage lending:

“Economic growth was moderate during the first half of the year, but the tightening of credit conditions has the potential to intensify the housing correction and to restrain economic growth more generally. Today’s action [intends] to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and to promote moderate growth over time.”

FOMC Statement September 18, 2007

Fed Lowers Rate Target Conclusion

It certainly seems that the Fed is responding to pressure from the financial community. The financial community wants them to ease its monetary policy in the face of increasing difficulties in the credit markets. In addition, they want them to help those who recently financed their home purchase with an adjustable rate mortgage. Needless to say, this is probably not good news for the US dollar. As a result, the dollar continues to depreciate in value relative to other major currencies. After reading the FOMC statement, we realized there may be a rougher patch ahead.

Fed Lowers Rate Target

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