Question

Review the data for the Federal Funds Rate again. Suppose it is 2014 and the board of governors believes we are about to enter into another recession. Based on where the Federal Funds rate already was at that time, what problem might the FOMC encounter when they attempt to stimulate the economy by purchasing t-bills?

Answer 1

Whenever, commercial banks have a shortfall of money available with them, they may avail loans from the Central Bank in the United States which is known as the Federal Reserve. The Federal Reserve then charges them an interest rate which is also known as federal funds rate. This rate also decides the rate at which commercial banks would grant loans to retail loan takers and provide interest to the depositors in return.

In 2014, the Federal Fund rate was only at about 0.09% which is an extremely low interest rate at which banks could avail loan from the Federal Reserve. This was done as a measure to make sure that the availability of credit in the society was large enough.

Now, coming over to the Federal Reserve purchasing T bills in the open market, this is done primarily with a view to increase the flow of money in the economy. As the federal reserve purchases T bills, the economy then has an additional supply of money running with those that sell their bonds. For example, when a bank sells its bonds it receives money in return and that can be used to expand business operations.

Now, when the demand for bonds increases as the Federal Reserve is purchasing the same, the prices of the bonds increase as a result of which the interest rates fall. For example, if the price of a bond is valued at 100$, with a dividend of 5$ a year, the rate of return is expected to be 5% per year, However, due to the purchase done by Federal Reserve if the price of the same bond now is 110$, the rate of interest reduces to 4.5%.

Thus, as the Federal Reserve purchases T bills, the interest rates are lowered down even further. In the current scenario wherein the Federal Funds rate which are representative of the interest rates in the country are extremely low at 0.09%, therefore, the government in this situation cannot reduce the interest rate any further and purchasing t bonds in this market may result in negative interest rates wherein the value of the currency may depreciate. Thus, in the current situation the purchase of bonds is not possible as it would have an adverse impact on the value of the currency itself.

For example, if investors do not get interest rates from banks, but rather are required to pay money to the banks to keep their money due to negative interest rates or 0 interest rates, then investments in the country may be impacted and people would not prefer to enter such market types thus reducing the flow of money in the economy.

We can conclude by saying that in the year 2014, the Federal Funds rate was so low that purchasing t bills would have a negative impact on the economy as there is no room for interest rate corrections and investments would be lowered down to a level that foreign retail investors may not prefer the country anymore.

Please feel free to ask your doubts in the comments section.