Explanation of Federal Funds Rate Decisions
When the Federal Open Market Committee wishes to reduce interest rates they will increase the supply of money by buying government securities. When additional supply is added and everything else remains constant, price normally falls. The price here is the interest rate (cost of money) and specifically refers to the Federal Funds Rate. Conversely, when the Committee wishes to increase the Fed Funds Rate, they will instruct the Desk Manager to sell government securities, thereby taking the money they earn on the proceeds of those sales out of circulation and reducing the money supply. When supply is taken away and everything else remains constant, price (or in this case interest rates) will normally rise.
The Federal Reserve has responded to a potential slow-down by lowering the target federal funds rate during recessions and other periods of lower growth. In fact, the Committee's lowering has recently predated recessions, in order to stimulate the economy and cushion the fall. Reducing the Fed Funds Rate makes money cheaper, allowing an influx of credit in to the economy through all types of loans.
The charts linked below show the relation between S&P 500 and interest rates.
- July 13, 1990 — Sept 4, 1992: 8.00%–3.00% (Includes 1990–1991 recession) rate drop chart rate rise chart
- Feb 1, 1995 — Nov 17, 1998: 6.00–4.75 rate drop chart1 rate drop chart2 rate rise chart
- May 16, 2000 — June 25, 2003: 6.50–1.00 (Includes 2001 recession) rate drop chart1 rate drop chart2 rate rise chart
- June 29, 2006 — (Oct. 29 2008): 5.25–1.00 rate drop chart
- Dec 16, 2008: 0.0–0.25
Bill Gross of PIMCO has suggested that in the past 15 years, every time the fed funds rate was higher than the nominal GDP growth rate, assets such as stocks and/or housing always fell. He even suggested that the best way to price the fed funds rate would be 100 basis points, or 1%, below the nominal GDP growth rate.
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