"Americans dined out less as inflation surged this summer, but couldn’t resist shelling out more at coffee and pastry shops.
Total
consumer spending fell 3.1% in June from a year earlier at the
restaurants analyzed in a report by the financial-services provider
Rabobank using data from Earnest Research. But spending at coffee shops
and bakery cafes rose 1.9% during the period, the report said.
Analysts,
economists and coffee drinkers offer varied explanations for the
resilience of caffeine and sugar suppliers, including the pleasure of
relatively small indulgences during a time of belt-tightening."
[One coffee drinker said] "“It’s not really going to eat into my budget if I’m just going every once in a while,”" [when the share of your budget spent on a good is low, its price elasticity of demand will be low so that for any given price change quantity demanded will not change much]
"Many consumers are hooked on their routines as much as the stimulants"
"Some
analysts said the relative health of coffee and pastry purveyors in June
could be a reflection of the return of more workers to offices. “The
basic hypothesis is that when you commute, you will buy more in coffee
shops,” said David Tinsley, senior economist at Bank of America
Institute. “You’re quite likely to buy one going into work. You’re quite
likely to buy your lunch or another cup of coffee in the afternoon.”
The
average price of a cup of a coffee in a quick-service shop was $4.90 in
the first six months of this year, up 7.6% from the same period last
year" [if they are saying that coffee costs 7.6% more than 12 months ago, then that is pretty close to the overall inflation rate so we would not expect sales or quantity demanded to be affected too much]
"Brewing at home was more expensive, too. The price of coffee increased 15.8% in June from a year earlier and rose 20.3% in July, according to the Labor Department." [if coffee you brew at home is a substitute for coffee from a shop then when the price of store bought coffee increases the demand for a substitute will increase. That would help explain why the coffee shops are doing okay]
"Alfredo Romero, economics professor at North Carolina Agricultural and
Technical State University, said, “There are some things that people are
slower to let go of, and one of those things is coffee.”" [that could be consistent with the earlier statement about people being hooked on stimulants which would mean that there are not many good substitutes for coffee and goods with few substitutes have a low price elasticity of demand]
"But one
characteristic of today’s economy is that job cuts at small startups and
large companies have yet to dent the overall labor market. Labor demand
is still historically strong, offering only faint signs of cooling.
There are nearly two job openings for every unemployed person
seeking work. That means many workers who are losing their jobs are
quickly landing jobs. Some are even weighing multiple offers and
accepting positions that pay more and better align with their skills.
“With
unemployment so low, job openings so high and the quits rate so high,
we’re finding that the balance of power is still with the job seeker,”
said Paul McDonald, senior executive director at staffing firm Robert Half.
Initial jobless claims, the number of applications for state unemployment benefits, have risen this summer
after hitting a half-century low in the spring. In the week ended Aug.
13, a seasonally adjusted 250,000 workers filed for benefits, above the
2019 prepandemic average of 218,000 and a sign that layoffs have ticked
up.
Meanwhile, continuing claims, a proxy for the number of people claiming
ongoing jobless benefits, have increased at a much slower rate.
Continuing claims were about 1.4 million in the week ended Aug. 6, below
their 2019 average of 1.7 million. Relatively low and stable continuing
claims could indicate workers are leaving unemployment rolls quickly as
they regain employment, some economists say."
"The typical unemployed worker had been off the job for 8.5 weeks in
July, down from 14.4 weeks a year earlier, according to the Labor
Department. The shorter duration of unemployment suggests many
unemployed Americans are finding jobs fast as fewer leave the labor
force, said Julia Pollak, chief economist at ZipRecruiter.
Shorter episodes of joblessness defy economists’ concerns earlier in the pandemic that workers would suffer from long-term spells of unemployment of 27 weeks or more like they did after the 2007-09 recession.
The share of all jobless Americans unemployed for less than five weeks
surpassed the share of those out of work for at least 27 weeks in
January, according to the Labor Department. The gap has since widened.
By July, nearly 37% of unemployed workers had been out of work less than
five weeks, roughly double the percentage experiencing long-term
joblessness."
"Employers
had 10.7 million unfilled jobs in June, down from a record of 11.9
million in March, but still well above the 7 million job openings in
February 2020 ahead of the pandemic, when the labor market was also
booming.
Job-openings
rates across industries are much higher than before the pandemic hit,
suggesting companies still need workers even in sectors where company
layoffs have been pronounced, such as technology, real estate, finance
and insurance.
Longer periods of unemployment can allow job seekers more time to search for roles that match their skill sets,
some economists say. But with job opportunities so abundant, many
unemployed workers are finding jobs that suit them within a matter of
weeks or even days."
Attendance remains below prepandemic levels, but Disneyland and Disney World are making more money than ever. The company has raised some prices and eliminated or started charging for other services and features that used to be free.
"These days, Walt Disney Co. DIS -2.89%▼ has a new magic trick: wringing every last dollar out of each visitor to its profitable theme parks."
"The results reflect a major strategic shift on Disney’s part, where the
company is focused less on maximizing the quantity of visitors and more
on increasing how much money each visitor spends, an approach the
company refers to as yield management. Improving the visitor experience,
the thinking goes, will prompt guests to spend more hours—and therefore
more money—at the parks because they are having such a good time."
"The
biggest change in the past two years—and the most lucrative for
Disney—is the introduction of a smartphone-app feature called Genie+
that costs $15 per person a day, on top of the price of admission, and
allows parkgoers to skip the unreserved lines for some attractions,
which the company refers to as “standby.” But Genie+ doesn’t cover
everything. To skip the standby lines at the most sought-after
attractions, including some Star Wars and Guardians of the Galaxy-themed
rides, reservations now cost an additional $10 to $17. Standby waits
for popular attractions can last hours.
At the same time, many benefits that used to be free—from
parking for certain annual passholders to airport shuttles to MagicBand
wristbands that serve as combination hotel-room keys and park
passes—have been eliminated or now come with a price."
"Disney’s theme-park pricing is determined by “pure supply and demand,”
said a company spokeswoman. “No different than airplanes, hotels or
cruise ships.”"
"annual passholders at Disneyland account for about one half of annual
visits—but . . . annual passholders tend to spend less than
other visitors per visit"
"A typical annual pass holder might ride only one ride during a visit,
eat an ice cream cone and walk around for a few hours, taking up
capacity that might otherwise be used by out-of-state visitors"
"About half of visitors to the parks pay for and use Genie+"
"of those who pay for Genie+, 70% say in post-visit surveys that they plan to do so again"
"Disney has stopped selling nearly all new annual passes to Disneyland
and Walt Disney World and has done away with a host of free perks that
annual passholders used to enjoy. Existing annual passholders can renew
their passes, although earlier this month, the company raised the
renewal price for its highest-tier annual passes to Disneyland by 14%,
to $1,599 from $1,399, while at the same time introducing more blackout
days when passholders can’t visit"
"The new
reservation system has allowed the company to limit attendance without
having to turn visitors away when the parks become overcrowded, as it
occasionally did in previous years.
The
company also points out that it offers frequent promotions, including
discounted room rates at its hotels, packages that become more
economical the more days a visitor spends at the park, and discounts for
residents of Southern California and Florida."
"Some longtime fans who come to the park regularly, and aren’t splurging
on once-in-a-lifetime memories, complain about the new fees."
"The
Genie+ app feature replaced a system known as FastPass that used to come
free with any ticket sold at Disneyland or Walt Disney World. The new
service—along with a free version, known simply as Genie—does more than
make Disney money: It also helps the parks’ operators direct traffic and
spread people around the parks more evenly, to reduce waiting times
overall, and upsell visitors by offering them promotions on food,
merchandise and ride-reservation fees.
Each
park has an operation center with a “heat map” that tracks where Genie+
users are in the parks using GPS technology. Park operators can direct
traffic using the app by notifying visitors where the shortest lines are
and offering food and merchandise promotions to cajole them to other
areas.
“If
I’m seeing too much activity on the west side, I’m able to spread where
I direct people to the east side,” Mr. D’Amaro said. “Our attractions
will be load-balanced better, and lines will be shorter, and what that
means is the experience will be better.”
In
an analysis for The Wall Street Journal, Touring Plans analyzed room
prices, including taxes, at three popular Walt Disney World hotels over
the past decade, and found increases that far outpaced inflation, which
in July hit a record high of 9.1%."
"Prices for tickets and certain food items have also climbed faster than
inflation over the past decade, the Touring Plans analysis found. Disney
fan blogs have noted that classic purchases at Disney parks, including
the pineapple Dole Whip frozen treat ($5.99 last year, $6.99 this year
at some locations) and studded Mickey Mouse-ears headbands ($29.99 last
summer, now $39.99) are quickly getting costlier, outpacing inflation."
In economics we say that people want to maximize their utility. They buy the combination of goods that will make them happiest.
These three economists had some interesting observations about this.
Frank Knight was an economics professor at The University of Chicago
in the first half of the 20th century. John Stuart Mill was a British
philosopher and economist in the 19th century.
Here is an interesting quote from Knight followed by a similar one from John Stuart Mill.
"Life
is at bottom an exploration in the field of values, an attempt to
discover values, rather than on the basis of knowledge of them to
produce and enjoy them to the greatest possible extent. We strive to
'know ourselves,' to find our real wants, more than to get what we want"
Source: Knight, Frank H. 1935. "The Limitations of Scientific Method in Economics," in The Ethics of Competition and other Essays. Harper and Row: New York.
I read something about Nobel Prize winning economist James Buchanan today that reminded me of what Knight and Mill said. See Some Economics of James Buchanan by Timothy Taylor (the post is very interesting, raising questions about what economics is). This excerpt is a quote from Buchanan:
"In one sense, the theory of choice presents a paradox. If the utility function of the choosing agent is fully defined in advance, choice becomes purely mechanical. No "decision," as such, is required; there is no weighing of alternatives. On the other hand, if the utility function is not wholly defined, choice becomes real, and decisions become unpredictable mental events. If I know what I want, a computer can make all of my choices for me. If I do not know what I want, no possible computer can derive my utility function since it does not really exist."
All of this raises questions about utility functions. Do we have them? Do they change over time? If they do, how and why?
We say that tastes and preferences are one of the shift factors for demand in economics. If the taste for something increases, then demand increases. But normally we don't say much about why tastes change.
Mill and Knight both seem to be saying that life is finding out what your tastes are. If that is the case, maybe, like Buchanan says, a computer could not make decisions for us.
"The state’s High Plains region, which covers 41
counties in the Texas Panhandle and West Texas, is home to more than
11,000 wind turbines — the most in any area of the state.
The
region could generate enough wind energy to power at least 9 million
homes. Experts say the additional energy could help provide much-needed
stability to the electric grid during high energy-demand summers like
this one, and even lower the power bills of Texans in other parts of the
state.
But a significant portion of the
electricity produced in the High Plains stays there for a simple reason:
It can’t be moved elsewhere. Despite the growing development of wind
energy production in Texas, the state’s transmission network would need
significant infrastructure upgrades to ship out the energy produced in
the region."
"“Because there’s not enough transmission to move it where it’s needed,
ERCOT has to throttle back the [wind] generators,” energy lawyer Michael
Jewell said. “They actually tell the wind generators to stop generating
electricity. It gets to the point where [wind farm operators] literally
have to disengage the generators entirely and stop them from doing
anything.”"
"wind farms across the state account for nearly 21% of the state’s power generation."
"Wind energy is one of the lowest-priced energy sources because it is
sold at fixed prices, turbines do not need fuel to run and the federal
government provides subsidies. Texans who get their energy from wind
farms in the High Plains region usually pay less for electricity than
people in other areas of the state."
"A 2021 ERCOT report shows there have been
increases in stability constraints for wind energy in recent years in
both West and South Texas that have limited the long-distance transfer
of power.
“The transmission constraints are
such that energy can’t make it to the load centers. [High Plains wind
power] might be able to make it to Lubbock, but it may not be able to
make it to Dallas, Fort Worth, Houston or Austin,” Jewell said. “This is
not an insignificant problem — it is costing Texans a lot of money.”"
"the Public Utility Commission, which oversees the grid, is conducting
tests to determine the economic benefits of adding transmission lines
from the High Plains to the more than 52,000 miles of lines that already
connect to the grid across the state. As of now, however, there is no
official proposal to build new lines.
"“It does take a lot of time to figure it out — you’re talking about a
transmission line that’s going to be in service for 40 or 50 years, and
it’s going to cost hundreds of millions of dollars,” Jewell said."
"while transmission upgrades across the state have generally been made
in a timely manner, it’s been challenging to add infrastructure where
there has been rapid growth, like in the High Plains."
This is the title of an article that was published recently and was actually in Spanish by Rafael Galvão de Almeida. He is at Universidade Federal de Minas Gerais, Brasil. The title in Spanish is "Camelot Elétrica: Um Economista Visita a Corte do Rei Arthur."
It was published in the journal "História Econômica & História de Empresas" which means "Economic History & Business History." Click here for more information.
Here is the abstract:
"Mark Twain wrote the book A Connecticut Yankee in King Arthur's Court(1889) as a way of reflecting on the changes taking place in the United States of the so-called “Golden Age”. The book tells the story of Hank Morgan, an engineer who ended up in 6th century England, when King Arthur led the Knights of the Round Table in Camelot. Hank attempts to industrialize England twelve centuries earlier, using his knowledge of technology and culture. However, his Electric Camelot project, over numerous setbacks and failure. The novel is relevant to economists because it deals with various topics of interest, such as entrepreneurship and economic development. The literature on the “visiting economist syndrome” identifies numerous problems in a country’s development aid process due to a number of factors, including even the arrogance and naivety of economic models, but that are present when dealing with different contexts. It is argued that these problems were discussed by Mark Twain, who was interested in the nascent neoclassical economics, in the novel in question. Although Hank is an engineer, his trajectory is similar to that of a visiting economist. Thus, the book is a tool to explore through fiction problems and challenges of economic development."
They are the ‘universal price’ at the base of an economy. Keeping rates artificially low has created an addiction with its own cost.
By historian Adam Rowe. He reviews the book The Price of Time: The Real Story of Interest by Edward Chancellor. Excerpts:
"The practice of charging interest is as old as time itself. Before
Mesopotamians had learned to coin money or place wheels on carts,
lenders had established the practice of demanding more in the future of
whatever they made available to borrowers in the present. The etymology
of many of the words for interest derive from the offspring of
livestock, reflecting an awareness that wealth well managed is fruitful.
But the etymology also reflects a suspicion that interest allows the
rich to devour the poor. Ancient Hebrew words for interest include one
meaning “the bite of a serpent.”"
"From the beginning, Mr. Chancellor shows, rulers have tried to intervene
to soften the antagonism between borrowers and lenders. The earliest
set of laws, Hammurabi’s code in Babylon (from around 1750 B.C.), is
preoccupied with regulating interest—setting maximum loan rates,
including 20% for silver and 33.33% for barley. A millennium later,
Athens’s renowned lawgiver Solon ordered all the stones recording
mortgages destroyed as part of an effort at moral and political renewal.
(His predecessor Draco, to whom we owe the word “draconian,” had forced
many debtors into slavery.) Thinkers and philosophers throughout
history—from Aristotle and Aquinas to Proudhon and Marx—have regarded
any rate of interest as unjust. Mere scribblers shared this view.
According to Daniel Defoe, “interest of money is a canker-worm upon the
tradesman’s profit.”"
"Of proto-capitalist 16th-century England, the historian R.H. Tawney
wrote: “The borrower was often a merchant, who raised a loan in order to
speculate on the exchanges or to corner the wool crop.” As for the
lender, he might well be “an economic innocent, who sought a secure
investment for his savings.”"
"Like any other price, the rate of interest reflects a complex balance of
forces in the real economy, from aggregate savings to future
expectations. When governments push that price too low—or too high—they
create distortions that are counterproductive and socially unjust."
"The price of securities tends to rise or fall inversely with the price
of interest. Those who own the most securities thus benefit the most
when interest rates fall."
"Low interest rates don’t help the poor, who don’t have access to cheap
credit. They do help people with formidable assets already, in part by
making leverage more attractive. With money so cheap, financiers can
boost investment returns with borrowed cash."
"Artificially low rates distort the decentralized decision-making process
of a market economy. Without interest, he writes, “capital can’t be
properly allocated and too little is saved.” Investors accept more risk
in pursuit of higher returns, making future growth seem more attractive
than current profits. And because interest is one of the chief costs in
finance, low rates shift economic activity from “real world” enterprises
to purely financial transactions."
"How does working from home change this picture? When workers can work
from home instead of driving into the office, this makes available a
new substitute for driving. Working from home is relatively cheaper than
driving, so many workers would prefer to work from home, if they can.
That makes demand for petrol more elastic. The change in elasticity will
be greatest for workers where working from home is a closer substitute
to working in the office. That will include workers who don't have to
drive towards work for other reasons, such as dropping kids off at
school, grocery shopping on the way home, etc.
The current high
price of petrol (as a result of the war in Ukraine, and unrelated to
working from home (as far as we know)), has probably reinforced the
increase in the price elasticity of demand. If petrol is now taking up a
higher proportion of household income, demand will tend to be more
elastic for that reason as well.
Combining those effects, demand
for petrol is more elastic now than it was before the pandemic led to a
large increase in working from home."
"Broad new
data on wages earned by college graduates who received federal student
aid showed a pay gap emerging between men and women soon after they
joined the workforce, even among those receiving the same degree from
the same school.
The
data, which cover about 1.7 million graduates, showed that median pay
for men exceeded that for women three years after graduation in nearly
75% of roughly 11,300 undergraduate and graduate degree programs at some
2,000 universities. In almost half of the programs, male graduates’
median earnings topped women’s by 10% or more, a Wall Street Journal
analysis of data from 2015 and 2016 graduates showed."
"Determining
why those gaps appear earlier isn’t simple. The federal data don’t
account for such factors as recipients of the same degrees seeking
different types of jobs and career paths, some of which pay far more
than others. Studies have shown that men tend to negotiate salaries more
aggressively than women, and women at times shy away from ambitious goals for fear of being unprepared. Even when women and men have identical academic credentials, women sometimes choose lower-paying career paths, pursuing a passion rather than a high paycheck.
The
median pay for men from the California State University, Fullerton,
nursing master’s program, for instance, was $199,000 three years after
graduation, compared with $115,000 for women. The school said that is
largely because women in the program gravitated toward nurse midwifery,
which pays less than specialties like anesthesiology.
Researchers also say that discrimination, despite laws against it, remains a factor in the gender pay gap at all career levels."
"Among those with undergraduate degrees, women out-earned men in just four of the 20 most popular areas of study"
"Across those 20 fields, men and women’s pay came closest to parity in economics, where women earned 1.4% more than men.
“There is no neat, tidy explanation” for the early-pay disparities, said Francine Blau, a Cornell University labor economist.
Researchers
say women choosing careers sometimes internalize societal expectations
about which jobs suit them. Well-intentioned advisers and employers can steer women toward less lucrative options, based on assumptions about their aspirations.
Graduates
of petroleum-engineering programs, among the highest-paying
undergraduate majors in the country, often take jobs either as field
engineers or data analysts. Career-service advisers and graduates said
women are more represented in the latter roles, which are based in an
office, involve more regular work hours and can pay less."
"Different
job tracks also can explain part of the pay gap at Michigan’s law
school, where men earned a median income that was 37% higher than
women’s three years out.
The
school said that in the classes of 2015 and 2016, 237 men took jobs at
law firms, while 158 women did. Fourteen men headed into public-interest
jobs, whereas three times as many women did. The classes those years
had slightly more men than women.
Several
women said in interviews that the mission-driven work appealed to them,
outweighing the draw of a higher law-firm salary."
"Several women who graduated from the San Antonio program noted that male
classmates launched their own practices—generally a more lucrative
path—sooner after graduation than female classmates, who often completed
residencies and worked for other dentists before buying or starting a
practice."
"The Federal Reserve sets two overnight interest rates: the
interest rate paid on banks' reserve balances and the rate on our
reverse repurchase agreements. We use these two administered rates to
keep a market-
determined rate, the federal funds rate, within a target range set by
the FOMC."
"The Federal Reserve (the Fed)
is the central bank of the United States. As the central bank, it serves
several key functions within the economy. One of the most important
functions of the Fed is to promote economic stability using monetary
policy. The Fed's goals for monetary policy, as defined by Congress, are
to promote maximum employment and price stability.
The Federal Open Market Committee (FOMC) is the monetary
policymaking arm of the Federal Reserve. The FOMC usually meets eight
times per year in Washington, D.C. These two-day meetings include a
review of economic data and financial conditions, briefings by
economists, policy discussions, and a vote on the setting of monetary
policy—including a decision about whether the FOMC will adjust its
target range for the federal funds rate. The federal funds rate is the
interest rate banks charge each other for overnight loans. The Fed sets a
target range for where it wants the interest rates charged to fall
within, and it is the setting of this range that the Fed uses to
communicate its monetary policy position.
Figure 1 The Federal Funds Rate Target Range
SOURCE: Board of Governors of the Federal Reserve System via FRED®, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/graph/?g=COX8, accessed April 4, 2022.
The FOMC conducts monetary policy by
setting the target range for the federal funds rate. This graph shows
the target range, determined by the upper and lower limits, and the
effective federal funds rate within the range.
Over time, as shown in Figure 1,2 the FOMC has moved the
target range up and down as it steers the economy toward maximum
employment and price stability. For example, once the economy recovered
from the global financial crisis, the FOMC moved the target range from
near zero at the end of 2015 up to 2¼ -2½ percent by early 2019. Then
when the COVID-19 pandemic hit, the FOMC quickly moved the target range
back to near zero.
What Is the Federal Funds Rate and Why Is It So Important?
The federal funds rate is a very specific short-term interest rate.
It involves the transfer of funds between banks that maintain accounts
(deposits) with their Federal Reserve Bank; the accounts are called reserve balance
accounts. The federal funds market is where banks that may need money
in their reserve accounts for cashflow reasons go to borrow from banks
that have excess funds in their reserve accounts. Banks who lend funds
act as suppliers of reserves in the federal funds market; banks who
borrow funds act as demanders of reserves in the federal funds market.
The federal funds rate is not "set" by the Fed, but rather determined by
the borrowers and lenders in the federal funds market.
Monetary policy is transmitted through market
interest rates to affect consumers' and producers' spending decisions,
which ultimately moves the economy toward the Fed's objectives—maximum
employment and stable prices. This monetary policy implementation
framework ensures that when the FOMC changes its policy stance (raises
or lowers the target range for the federal funds rate), market interest
rates and financial conditions move in the desired direction.
The FOMC conducts monetary policy by setting the target range for the
federal funds rate (Figure 2, Box 1). Then the Fed implements policy by
using its monetary policy tools to ensure the federal funds rate stays
within the target range (red arrow).
The federal funds rate is important because when the FOMC sets its
target range, it influences many other interest rates in the economy
(Figure 2, Box 2). In fact, by adjusting the target for this rate, the
Fed can influence the spending choices of consumers and producers
(Figure 2, Box 3) and ultimately move the economy toward maximum
employment and price stability (Figure 2, Box 4).
The Fed's Monetary Policy Implementation Toolbox
The Fed uses its monetary policy tools in the implementation phase.
In all, the Fed uses four key tools to help ensure the federal funds
rate stays within the target range set by the FOMC.3 We'll
use a simple supply and demand model (Figure 3) to describe how the
tools work together. Overall, these are the critical tools the Fed uses
because reserves in the banking system are ample. That is, the supply of
reserves, set by the Fed, is large enough that it intersects the demand
curve where it is nearly flat (see Figure 3).
In the ample-reserves framework, the Federal Reserve raises (lowers) its administered rates to move the federal funds rate higher (lower). Small shifts of the supply curve have little or no effect on the federal funds rate.
The Fed's Primary Tool: Interest on Reserve Balances
Today, the Fed's primary tool for adjusting the federal funds rate is
interest on reserve balances. The interest on reserve balances rate
(labeled "IORB rate" in Figure 3) is the interest rate paid on funds
that banks hold in their reserve balance account at a Federal Reserve
Bank. For banks, this interest rate represents a risk-free investment
option. Importantly, the interest on reserve balances rate is an
"administered rate," which means it is set by the Fed and not determined
in a market (like the federal funds rate is). In fact, there are two
key concepts that ensure interest on reserves is an effective tool.
The first concept is the reservation rate, which is the lowest
rate that banks are willing to accept for lending out their funds.
Banks can deposit their funds at the Federal Reserve and earn the
interest on reserve balances rate. Because depositing funds at the Fed
is a risk-free option, banks will likely not be willing to lend their
funds in the federal funds market for a lower interest rate than they
can earn from depositing their funds at the Fed. So, the interest on
reserve balances rate serves as a reservation rate for banks.
The second concept is arbitrage, which is the simultaneous
purchase and sale of funds (or goods) in order to profit from a
difference in price. For example, let's assume reserves are trading in
the federal funds market at 2 percent (i.e., the federal funds rate is 2
percent) and that reserves (deposits) at the Fed earn 2.5 percent
(i.e., the interest on reserve balances rate is 2.5 percent). Banks will
quickly see that they can borrow funds in the federal funds market at 2
percent and deposit those funds at the Fed and earn the interest on
reserve balances rate of 2.5 percent, which means that they can earn a
profit of 0.5 percent (the difference between the rates).The increase in
demand for funds in the federal funds market will put upward pressure
on the federal funds rate, and the federal funds rate will rise toward
the interest on reserve balances rate. This upward pressure on the
federal funds rate will continue until the federal funds rate has risen
to the level that banks no longer see the opportunity to profit.
So, arbitrage ensures that the federal funds rate does not fall far below the interest on reserve balances rate.
Arbitrage is the reason why these short-term rates remain closely
linked. In fact, arbitrage is what makes interest on reserve balances an
effective tool for guiding the federal funds rate. Because the Fed sets
the interest on reserve balances rate directly, the Fed can steer the
federal funds rate down or up by lowering or raising the level of the
interest on reserve balances rate. As a result, interest on reserve
balances is the Fed's primary tool for adjusting the federal funds rate,
but the Fed has other tools that play supporting roles.
Setting a Floor for the Federal Funds Rate: The Overnight Reverse Repurchase Agreement Facility
Interest on reserve balances is available only to banks and a few
other institutions. The Fed has an overnight reverse repurchase facility
that is open to a broader set of financial institutions. This facility
allows these financial institutions to deposit their funds at a Federal
Reserve Bank and earn the overnight reverse repurchase agreement rate
offered by the Fed. The overnight reverse repurchase agreement rate
(labeled "ON RRP rate" on Figure 3) works for these institutions similar
to the way the interest on reserve balances rate works for banks. So,
this rate acts like a reservation rate for these financial institutions,
and the overnight reverse repurchase agreement rate interacts with
other short-term market rates through arbitrage. The overnight reverse
repurchase agreement facility is a supplementary tool because the rate
the Fed sets for it helps set a floor for the federal funds rate (Figure
4).
Figure 4 Steering the Federal Funds Rate
SOURCE: Federal Reserve Bank of New York and Board of
Governors of the Federal Reserve System via FRED®, Federal Reserve Bank
of St. Louis;
https://fred.stlouisfed.org/graph/?g=LP47, accessed April 4, 2022.
The Fed implements monetary policy by using
its monetary policy tools, such as the interest of reserve balances
rate (red) and overnight reverse repurchase agreement rate (blue), to
ensure interest rates are consistent with the federal funds rate
target.
Setting a Ceiling for the Federal Funds Rate: The Discount Window
The discount rate is the rate charged by the Fed for loans obtained through the Fed's discount window.
Because banks will not likely borrow at a higher rate than they can
borrow from the Fed, the discount rate acts as a ceiling for the federal
funds rate: It is set higher than the interest on reserve balances rate
and the overnight reverse repurchase agreement rate (Figure 5).
When the Federal Reserve lowers its administered
rates, the end points of the demand curve shift down. The vertical
supply curve is unchanged. The demand curve intersects the supply curve
at a lower federal funds rate. In general, the Fed tends to lower all
the administered rates by the same amount, keeping the spread between
the rates constant.
The Final Tool: Open Market Operations
As noted above, the Fed's current method for implementing monetary
policy relies on banks' reserves remaining "ample." So, if the Fed needs
to add reserves to ensure they remain ample, it does so by buying U.S.
government securities in the open market. This action is known as open market operations.
When the Fed buys securities, it pays for them by depositing funds into
the appropriate banks' reserve balance accounts, adding to the overall
level of reserves in the banking system. As Figure 3 shows, open market
operations can be used to shift the supply curve left or right. Prior to
2008, open market operations were the Fed's primary monetary policy
tool, which it used daily to make sure the federal funds rate hit the
FOMC's target. Today this tool is mainly used to ensure that reserves
remain ample.
Now that you understand the Fed's implementation tools, let's see how
the Fed uses them to achieve its two goals: maximum employment and
price stability.
Expansionary Monetary Policy Using the Fed's Tools
Suppose the following: The economy weakens, with employment falling
short of maximum employment, and the inflation rate has been steady at
around 2 percent but is showing signs of decreasing. The FOMC might
decide to conduct monetary policy by lowering its target range for the federal funds rate. To implement
that monetary policy, it would decrease its administered rates—the
interest on reserve balances rate, overnight reverse repurchase
agreement rate, and discount rate—to ensure the market-determined
federal funds rate stays within the target range (see Figure 5). These
actions would transmit to other interest rates and broader financial
conditions:
Lower interest rates decrease the cost of borrowing money, which
encourages consumers to increase spending on goods and services and
businesses to invest in new equipment.
The increase in
consumption spending increases the overall demand for goods and services
in the economy, which creates an incentive for businesses to increase
production, hire more workers, and spend more on other resources.
As
these increases in spending ripple through the economy, likely moving
the unemployment rate down toward its full employment level, inflation
could possibly move up.
So, the Fed's monetary policy implementation tools can be effective
for moving the economy back toward maximum employment and price
stability when the economy is stalling.
Contractionary Monetary Policy Using the Fed's Tools
Suppose the following: The economy is showing signs of overheating,
with the unemployment rate very low and businesses finding it hard to
fill jobs, and the inflation rate has been above the Fed's 2 percent
target for quite some time and is rising. In this case, the FOMC might
decide to conduct monetary policy by raising its target range for the federal funds rate. To implement
that monetary policy, it would increase its administered rates—the
interest on reserve balances rate, overnight reverse repurchase
agreement rate, and discount rate—to ensure the federal funds rate stays
within the target range. These actions would transmit to other interest
rates and broader financial conditions:
Higher interest rates increase the cost of borrowing money and
raise the incentive to save, which dampens consumer spending on some
goods and services and slows businesses' investment in new equipment.
The
decrease in consumption spending decreases the overall demand for goods
and services in the economy, which will likely lead to a decrease in
production levels, fewer employees hired, and less spending on other
resources.
As these decreases in spending ripple through the
economy, demand for workers could lessen, inflationary pressures would
diminish, and the inflation rate would fall back toward 2 percent.
So, higher interest rates can be used to move the economy back to
maximum employment and price stability when the economy is overheating.
Conclusion
The Fed has a congressional mandate of maximum employment and price
stability. The FOMC conducts monetary policy by setting the target range
for the federal funds rate. Then the Fed uses its monetary policy tools
to implement the policy, which guides market interest rates toward the
Fed's desired setting of policy. The Fed ensures there are ample
reserves in the banking system and uses its administered rates to steer
the federal funds rate into the FOMC's target range: Interest on reserve
balances is the Fed's primary tool for adjusting the federal funds
rate; the overnight reverse repurchase agreement facility is a
supplementary tool that sets a floor for the federal funds rate; and the
discount rate serves as a ceiling for the federal funds rate. Changes
in the federal funds rate are transmitted to other interest rates
through arbitrage and affect the decisions of consumers and businesses.
Their decisions ultimately move the economy toward maximum employment
and price stability.
2 The effective federal funds rate is the
rate used in the figures in this article. On any given day, there are
many transactions that settle at slightly different federal funds rates.
The effective federal funds rate is the volume-weighted median rate of
these transactions.
3 The Fed recently introduced two
repurchase agreement (repo) backstop tools, the standing overnight repo
facility and the foreign and international monetary authorities repo
facility. These are used by specific counterparties to help set a
ceiling on repo rates. We do not discuss them here because this article
is targeted toward a principles of economics audience.
Arbitrage: The simultaneous purchase and sale of funds (or goods) in order to profit from a difference in price.
Discount rate: The interest rate charged by the Federal Reserve to banks for loans obtained through the Fed's discount window.
Facility: A standing program targeted at a set of
counterparties for depositing or lending. The Fed has permanent
facilities (like the discount window and the overnight reverse
repurchase agreement facility) as well as temporary facilities (like
those implemented during the Financial Crisis of 2007-09 and the
COVID-19 pandemic).
Federal Open Market Committee (FOMC): A Committee created by
law that consists of the seven members of the Board of Governors; the
president of the Federal Reserve Bank of New York; and, on a rotating
basis, the presidents of four other Reserve Banks. Nonvoting Reserve
Bank presidents also participate in Committee deliberations and
discussion.
Maximum employment: The highest level of employment that an economy can sustain while maintaining a stable inflation rate.
Open market operations: The buying and selling of government
securities through primary dealers by the Federal Reserve. When the
securities are bought or sold, reserves in the banking system are
increased or decreased, respectively.
Price stability: A low and stable rate of inflation maintained over an extended period of time.
Reservation rate: The lowest rate of return that banks are willing to accept for lending out funds.
Reserve balances (reserves): The deposits a bank maintains in its account with a Federal Reserve Bank."
