Impacts and purposes of Federal Reserve Bank monetary policy

Economically, the "Great Depression" had a much larger effect than the "Great Recession" according to the following infographic. However, what stands out the most is the increase in money supply, also known as liquidity, during the Great Recession. Specifically, the Federal Reserve Bank increased money supply by 125% whereas during the depression, the Federal Reserve only increased money supply by 17%.

The effects of such an aggressive monetary policy are economic stimulus via a decline in the value of the dollar, and more affordable interest payments on U.S. securities. To illustrate, when monetary policy facilitates lower interest rates on debt, variable rate U.S. treasury payments decline costing the country less. Also, when the government pays foreign governments interest on Treasury Securities, even if the interest rate remains the same, the value becomes lower as the dollar is worth less via looser monetary policy. Additionally, as the dollar declines, multinational corporations bringing money back to the U.S. that was earned in a foreign currency becomes worth more, nominally speaking.

Monetary policy is not without its critics however. This is evident in the second infographic below. Moreover, opponents of the Federal Reserve claim loose monetary policy creates asset bubbles, raises the cost of oil that is priced in dollars, facilitates higher national debt that is currently over $15 trillion, and decreases the worth of individual Americans via dollar devaluation and inflation.  What's more, since the Federal Reserve Bank has not been fully audited, the central bank lacks credibility per its skeptics.

How the Great Depression differs from the Great recession:

The Great Depression vs. The Great Recession by Payday Loan.co.uk

Why the Federal Reserve Bank's monetary policy is controversial:

Source: Best Accounting Schools

Financial News 06/06/2012: Exclusive Fed Spotlight

The Federal Reserve Has Created Over $2 Trillion In Less Than Four Years

Image attribution: US-PDGov

• Fed: Fed owns $853.6 billion in mortgage backed securities

• The Hill: The Fed's hands are gripped by election year politics
• BW: More central bank bond purchases ineffective per Fed official
• Huff Post: 3 Senators are attempting to restrict Fed independence
• BI: If unemployment does not decline, Fed stimulus a possibility

• NASDAQ: St. Louis Fed official says May jobs data insufficient

• FRB: Fed on board with CFPB, NCUA, FDIC & OCC per Dodd-Frank

• FRB: 06/07 release will add new credit-flow reporting per regulations

• Reuters: Chicago Fed official in favor of more debt monetization

• Bloomberg: Fed investigating JP Morgan for more moral hazard
  

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What Happened to the Federal Reserve Bank?

The thought of debasing economies in order for centralized banking powers to swoop in and globally centralize and consolidate financial and economic power sounds far fetched, but is it really? Naturally with any claim, a good way to find out is to actually investigate the facts to determine their validity. International banking is a centuries old institution so  really getting to the bottom of this question involves looking at the history of banking to connect the dots between current banking systems, and banking institutions. To find all the dots or greatly elaborate on this would conceivably take more than one blog post, but some of the bigger more obvious dots might help discern an outline of the basic picture of what happened to the Federal Reserve Bank.

Source: US PD

In the last two decades the Federal Reserve Bank has allowed economic bubbles to inflate and burst repeatedly indicating a likely awareness of how monetary policy was influencing the economy. This is corroborated by Lawrence H. White of the Cato Institute, despite mention of former Fed Chairman Allen Greenspan's denial of such. Moreover, a lowering of interest rates fueled the housing bubble that later became a housing crisis. This was embellished by deregulation that took place in the late 1990's and thereafter; for example,  the Gram Leach Bliley Act of 1999 aka the Financial Services Modernization Act which deregulated interstate banking services among other things.

The Federal Reserve was formed via a congressional compromise to solve decades of prior banking problems according to Mint. Whether or not bankers deliberately perpetrated an environment that could be exploited in this way is investigated by various research groups and investigations such as Political Research Associates. This group believes the Federal Reserve Act was indeed a congress wide bipartisan compromise, and not the result of a secret meeting between bankers and senators. 

The Center for Research on Globalization claims the Federal Reserve is owned by ten financial institutions including N.M. Rothschild of London, Rothschild Bank of Berlin, Warburg Bank of Hamburg, Warburg Bank of Amsterdam, Lehman Brothers of New York, Lazard Brothers of Paris, Kuhn Loeb Bank of New York, Israel Moses Seif Bank of Italy, Goldman Sachs of New York and JP Morgan Chase Bank of New York. If this is true then there may be reason to belief there is a least a conflict of interest. See Moneycation's October 19th and May 16th posts for more on this. 

The Federal Reserve bank has the power to lower interest rates through its monetary policy in addition to the ability to purchase assets in the open market. It was also formed to solve a banking crisis, but has contributed to future banking crises and is owned by a cluster of specific banks that may indicate of a conflict of interest. This makes sense given the nature of the bank is a hybrid of government and banking interests and a lot can happen in 100 years including a rerouting of those banking objectives. There may be confusion between conspiracy and mismanagement, where the former is about subversive plots and the latter is more about misguided policy.

The Shady Side of Banking

The following separate public complaints, legislative investigation and media reports about banking activities go as high up as the Federal Reserve Bank. On first impression they certainly show a dubious side to banking. What is demonstrated by these banking issues are questionable practices that may constitute extortion of money from tax payers, participation in conflict of interest, and violation of securities law all without serious repercussion.

Complaint 1: BofA shifting derivatives to FDIC insured accounts

This was reported by Bloomberg and highlighted by The Daily Bail on October 18th, 2011. Derivatives are the same type of financial instruments that caused the financial crisis of 2008; they are risky assets. To protect the bank from this risk the assets are claimed to have been moved to accounts that the Federal Depository Insurance Corporation insures. This is the same insurer that protects savings and checking accounts and is financing by the government. The complaint is that Bank of America is leaning on the U.S. Government, and hence U.S. Taxpayers, to hedge its risky decisions.

Complaint 2: Federal Reserve financing foreign governments

The Federal Reserve Bank is supposed to be the U.S. Central bank, not the global central bank or 'socialism for the wealthy'. It's primary mandate is portrayed to be the inflationary and economic concerns of the U.S. People, however  a legislative audit of the Federal Reserve Bank show $16 trillion in additional previously undisclosed liabilities, an amount not evident on its 'selected liabilities'  The fact these loans were not openly disclosed seems a little strange since the Federal Reserve Balance Sheet gives the impression of being complete, the Wall Street Journal does not show it on one of its versions of the Fed Balance sheet, and according to Senator Sanders of Vermont, a reasonable suspicion of conflict of interest occurs when banking officials receiving loans also serve the Federal Reserve Bank. The following video elaborates on this issue.

Complaint 3: JP Morgan Chase manipulating silver price

This particular concern has been spearheaded by Max Kesier of the Keiser Report on Russian Television. The claim, as illustrated in the video below is that JP Morgan Chase & Co. (JPM) practiced naked short selling, a trading method in which shares not owned are traded, with the aim of price manipulation.  A congressional hearing also took place in regard to this.

Complaint 4: Banks using loan loss reserves to report profits

This is a recent concern during Q3 2011 earnings season in reference to Citi Group in particular. NDTV describes how Citigroup earned 74 percent in Q3 using loan loss reserves to offset bad loan expenses. The accounting basis for this is also described in an October 17th, 2011 Moneycation Financial News reference to the Economic Review.

Inflation as an extended source of economic stimulus is questionable

In a back issue of the New Yorker Magazine the idea of inflationary stimulus is discussed as a way to facilitate debt reduction and possible increases to consumer spending. The example given in the magazine is debt accumulated by the United States during the 1940s as it became more manageable after inflation. This is because the debt management metrics were presumably not chained to inflation, and therefore as the amount of currency within the system increased, old debts shrunk proportionally to the money supply. The subsequent paying off of such debt then increases confidence in the economy and causes its borrowing costs to decline.

This strategy has been suggested as a remedy for the current weak U.S. Economy by experts such as Harvard Professor Kenneth Rogoff in a PBS interview. Moreover, when a central bank prints more money or indirectly increases the money supply via open market operations, the value of equity and commodities rise. In one sense this is good if those commodities are local. However, when they are not, as in the case of imported oil, inflationary pressure serves as a financial weight or tax to consumers. In the case of inflation of equity and oil commodities, artificially inflated 401(k) values counteract consumer price increases. However, this balancing out combined with a decline in national debt could perhaps serve as an economic stabilizer by not allowing things to get worse.

When an economy has systemic issues not tied to inflation, the above measures are not as effective. Moreover, inflation that's costs are paid for by the government also cancel out lowered debt. For example, a rise in healthcare costs paid for by government services such as Medicare does little to improve an economy that has lowered its debt burden via central bank monetary policy on interest rates. Additionally, exports can rise when the value of the dollar declines. However, that's no guarantee businesses won't up prices to keep up with costs. The value of currency also declines with inflation in which case individual net worth declines with out the proper inflation protection.

Increasing inflation at a slow rate can correspond to economic expansion when the amount of real national product increases and inflation rate rises along with it. This kind of inflation is not necessarily fiscally toxic, however higher levels can be risky. For example, if inflation rises too high, confidence in national Treasury Securities can wane causing higher costs to the government. The Federal Reserve Bank takes its inflation management seriously, and monetary policy that is too loose can cause it to increase. This makes the addition of a third round of quantitative easing by the Federal Reserve Bank questionable amidst an inflation rate that has risen to approximately 3.6 percent as of June 2011 per the Bureau of Labor Statistics.

A measured amount of inflation can be helpful, and can cushion the affect of a recession. Over a prolonged period of time however, an above rate of inflation has an eroding affect where the net benefits of lower cost of national debt and increased equity values don't stop the problem they were meant to ease i.e. the economic affects of recession. This is because the expenses for consumers and government continue to rise without economic growth leasing to less overall national worth with a higher denomination of asset values. Systemic economic issues have to be dealt with while inflationary stimulus serves to make it easier. When that doesn't work, as economists and observers have noted, the affects of monetary policy decline.

Do Permanent Open Market Operations Affect the Stock Market

In the spring of 2009, the New York Federal Reserve Bank, a component bank of the U.S. Federal Reserve Bank, announced it would initiate what was to be called Permanent Open Market Operations which has since been abbreviated to POMO by market commentators and investors.

The purpose of the Permanent Open Market Operations is to counterbalance inflows and outflows from the Federal Reserve Bank. By adjusting its balance sheet of assets and liabilities, the Federal Reserve Bank can also maintain the available amount of money supply which in turn affects market liquidity i.e. how much money is in the economy.

To illustrate how a Permanent Open Market Operation transaction would work, the relationship with 'primary dealers' is an important consideration. Primary dealers are the counterparties that agree to help facilitate the Federal Reserve Bank's objectives by either buying or selling financial securities from the bank.

Three of the POMO primary dealers are Barclays Capital Inc., Goldman Sachs & Co, and Deutsche Bank Securities Inc. For example, on September 9, 2010 the New York Federal Reserve Bank purchased $1.35 billion in financial securities from one or more of its primary dealers. Securities bought and sold in such transactions may include financial instruments such as mortgage backed securities, and government bonds.

When a Permanent Open Market Operation purchase is made from primary dealers, money enters the financial system via these banks. These banks may in turn reinvest this money in a way that influences the stock market. Since primary dealers may also be investment banks that serve as 'market makers', they potential to influence securities prices exists, and is contended to be present basis for stock market manipulation by some market observers.

To test whether or not the theory of market manipulation is true, one can contrast specific POMO transaction dates and observe market movements in indexes for those particular dates. According to the Federal Reserve Bank of New York, nine Treasury Coupon Purchases were scheduled between August 17, 2010 and September 13, 2010. Between August 17 and September 9, the Dow Jones Industrial Average approximately traded within the 10,000-10,400 range moving in both directions despite eight of nine purchases from primary dealers.

Another way to see if POMO transactions influence stock market values is to compare cash flows. For example, according to NYSE Technologies Market Data, on September 8, 2010, over $25 Billion in dollar volume was traded on the NYSE. Yet, if this dollar volume does not itself take into account leverage, the number could plausibly represent $250 billion. Now assuming net leveraged dollar volume for all U.S. exchanges is closer to somewhere between 1-25 trillion dollars, the POMO transaction is minimal with only $1.35 billion of cash inflow to primary dealers. Even if the amount is equally leveraged to $10s of billions as reported by Tyler Durden on Zero Hedge, the amount of financial influence might only range from around half a percent to 10 percent at best.

There is room for speculation as to whether or not the Federal Reserve Bank of New York does have the capacity to move market indices such as the Dow Jones Industrial Average on a consistent basis. At the least, it would seem a large cooperation would be needed from the use of  additional funds made available through primary or other dealers. Moreover, the technical indicators of the market suggest a trading range for the DJIA for most of the period of the aforementioned POMO purchases despite the uni-directional flow of money into the primary dealers facilitation. Further review of the technical indicators however shows significance price movements before and following the initiation of the Federal Bond Purchasing Program indicating a possible correlation.

Sources:

1. http://bit.ly/4widM0 (NY Fed)
2. http://bit.ly/apRffP (Zero Hedge)
3. http://bit.ly/ctJP2m (NYSE Market Data)

Are Federal Reserve Quantiative Easing Programs Helpful to Markets?

Quantitative easing is a term used to describe a form of economic stimulus offered by the Federal Reserve Bank to help boost market activity including business lending. This type of economic aid is an alternative to government funded investments, tax breaks and subsidizing. In the case of the U.S. Government, as of October, 2010, deficit spending has become so high that it has reached levels near that of World War II and the Great Depression. Hence, the assistance of the Federal Reserve Bank is seen as a viable alternative to increase business and lending activity. This however, may not be as beneficial to business and market activity as some predict for more than one reason.

The first reason quantitative easing by the Federal Reserve might not be as helpful as intended is method. On October 27, 2010, reports that the U.S. Federal Reserve bank would only place hundreds of billions of dollars into the economy via treasury purchases over three months caused concern. This is due in part to market psychology, and second, due to actual quantitative availability of funds for potential lending, spending and investment. Skeptics became concerned that a gradual and cautious approach to a second round of Federal spending in a way that did not mirror an earlier version was not the amount priced into market values.



Another reason why quantitative easing from the Federal Reserve Bank may not be as helpful to the U.S. Economy as expected is asset management. That is to say, if the balance sheet of large banks to whom federal funds will be available do not see good reason to spend, then they might not. This is evident in the early 2000's Japan pumped billions of dollars worth of Japanese Yen into its economy via a quantitative easing program of its own. However, the quantitative easing excluded the desired effect of strong economic stimulus. The reason for this according to a Federal Reserve report by Takeshi Temura and David Small was because of cautious asset management on behalf of banks i.e. financial intermediaries that didn't want to take on additional risk to their already risk tainted asset portfolios.

According to an October 27, 2010 MarketWatch interview with Jon Hilsenrath, a writer for the Wall Street Journal, when the Federal Reserve buys bonds via a quantitative easing program, it has an equivalent  affect as lowering the Federal Funds rate by 50-75 basis points or between .5-.75 percent. Since the Federal Funds rate was .25 percent in October, 2010, that would be similar to the effect of a negative interest rate in which the potential yields that banks could obtain from borrowing money would rise due to low cost. Instead, the larger availability of money is intended to increase market prices by encouraging demand. With higher market prices, comes a theoretical greater wealth, or wealth like affect on the economy.

In light of the above reasons, whether or not quantitative easing by the Federal Reserve bank will be helpful to the market depends on banking decisions in addition to borrowing activity. Without bank investment or increased lending activity, the intended purpose of quantitative easing may not be accomplished. Banks existing assets need to perform well enough to justify additional risk taking or additional risk taking has to be low enough to offset existing risky assets. If financial institutions decide the increased availability of money is to their advantage, they may see opportunities somewhere if not domestically, that on a medium to long-term time horizon may yield economy friendly banking profits.

Sources: (Date of record, October 27, 2010)

1. http://bit.ly/9E2cxu  (Wall Street Journal)
2. http://bit.ly/apVsC1 (Federal Reserve)
3. http://bit.ly/9J9tE0   (Federal Reserve Statistical Release)
4. http://bit.ly/bMqf39   (MarketWatch)

Financial affects of currency wars on investments

Currency wars can lead to investment inflation, and a kind of translucent wealth that is only made visible by the illusion of value. In other words, currency wars can stimulate economic activity, and investment value, if only in the short-term, and at a cost that can impact the overall wealth of consumers.

To illustrate further, currency wars are contests to outbid international competitors to improve sales of a nations products and services. Just like storefront price wars, countries in price wars attempt to keep the valuation of their currency below their competitor in order to boost economic activity.

China, Japan and the United States are all believed to be showing signs of a currency showdown as 2011 approaches. Currency showdowns, price war and competitive devaluation essentially refer to the same thing. The tools of currency wars are quantitative easing and money supply; both make it easier for banks to borrow and lend money by either increasing money supply or decreasing the cost of borrowing money. Currency wars occur when economies are seeking to either maximize growth or supplement weak growth. The affect on financial markets is increased liquidity by investment banks that may see leverage opportunities amidst lower market prices.

In October 2010, the Bank of Japan, a central bank that carries out monetary policy, advanced its quantitative easing plan by reducing its interbank lending rate to zero percent, a move similar to that of the U.S. Federal Reserve Bank. Between December 2008 and October 2010, the Federal Funds Rate was held at a quarter percent. The one month London Interbank Offered Rate (LIBOR) is similar to the Fed Funds Rate and has also been quite low for almost as long i.e. below .53 percent since January, 2009.

When interest rates decline, it can also affect currency valuation in the foreign exchange market. For example, the price of the United States Dollar rose against the Japanese Yen may rise when the Bank of Japan lowered its interest rate to zero. This, at least temporarily, made it more expensive to purchase U.S. goods and services but made U.S. consumers a little wealthier in terms of international spending power.

The problem with currency war is the financial and economic damage that has an increased risk of being created by excess liquidity. For example, if U.S. monetary policy produces too much money, the cost of living can actually rise for Americans during a time where wage pressure is high. Loose monetary policy can also cause central banks to buy gold and other assets to hedge their currency asset holdings. For example, the Wall Street Journal reported emerging markets were buying gold in 2011 to diversify their portfolio reserves.

This can make it more difficult to save and invest in the long-term unless proper measures of inflation protection are taken both in terms of individual household wealth and national economics. Large amounts of currency liquidity can also reduce businesses spending power when the majority of their profits are earned domestically. Another possible fiscal bi-product of this lower spending power, is further erosion competitive positioning of U.S. corporations, share prices and the industrial sectors they compete in.

In addition to potentially negative affects of price wars on investments via a decline in competitive positioning and market share of domestic companies, quantitative easing can reduce confidence in the national currency.

When international confidence in a currency wanes, economic power declines because things like Foreign Direct Investment (FDI) and financing of government debt instruments such as U.S. Treasury Notes declines. For the U.S. the possibility of not remaining the international reserve currency can also increase leading to dampening of economic control prospects both nationally and internationally.

In the United States, liquidity measures are the remedy for an economy that needs growth stimulus; exports also help. In China, a low Yuan-Renminbi has helped its exports and it has been reluctant to increase the value of its currency to maintain growth encouraged by these exports. For the U.S. this means the risk of being priced out of export markets increases thereby indirectly jeopardizing its workforce through lower product and service demand.

The affects of currency wars can be felt by individuals, investors, businesses and economies world wide depending on the size and scale of the currency showdown. If national trade and account deficit values do not decline despite quantitative easing measures it either means national deficit spending rises despite an increase in earnings, or that earnings have declined further in proportion to spending.

This is a sign a currency war is not achieving its desired affect. The second fiscal quarter of 2010 yielded a U.S. Account Deficit of $123.3 billion according to the Bureau of Economic Analysis (BEA). Currency wars can also under price valuable goods and services thereby undermining the very economies they attempt to leverage.

Sources: (Date of record, October 20, 2010)

1. http://bit.ly/aOhawU (Bureau of economic analysis)
2. http://bit.ly/9IGV1u (Federal Reserve Bank)
3. http://yhoo.it/afbBGh (Yahoo Finance)
4. http://bit.ly/d356KF (WSJ Prime Rate)

How to Read Federal Reserve Reports to Guide Your Investment Decisions

Federal Reserve reports and research can guide investment decisions by providing useful economic data reflective of business, market , commercial and economic conditions. The U.S. Federal Reserve Bank or FED for short is the semi-private national central bank of the United States that both gathers and releases economic data. This data can be found at the Federal Reserve website, and the websites of the Federal Reserve Regional Banks.

Federal Reserve reports include a variety of financial and economic information related to the banking industry, the economy as a whole and aspects of the economy that help investors uncover investments insights, fundamental data, and economic patterns relevant to investment decision making.

Types of Federal Reserve reports

The types of Federal Reserve reports include key data such as current and historical statistical releases, survey data, spreadsheets, industrial manufacturing information, research on possible future economic scenarios, and emphasis on national banking research, records and analysis.

Federal Reserve reports may also provide pertinent information on banking legislation and policies that can have an impact on businesses and/or banks. Each Federal Reserve report contains information on different parts of the economy that specify recorded variables that can help guide an investment decision. For example Federal Reserve reports include numbers on economic activity, production, employment, cash flow which can tell a reader of the report what has happened to that aspect of the economy over time and/or for a particular time period.

This data can also be further analyzed via statistical software to establish additional economic relationships for investment purposes. Samples and examples of Federal Reserve reports to guide your investment decision are listed below:

• Industrial production and capacity utilization
• Consumer credit outstanding
• Aggregate reserves of depository institutions
• Economic analysis studies
• Banking practices involving customers
• Federal Reserve letters

Each Federal Reserve report covers an economic or banking topic that is relevant to investors because the information in the Federal Reserve reports may reveal trends, financial events, probabilities and forecasts that could serve as financial indicators. In other words and for example, the Federal Reserve report on industrial production in July through September 2009 indicates an increase of 2.8%.

The capacity utilization chart shows how much of the industrial sector’s productive ability is being used which may be important to investors interested in putting money in industry where manufacturing and capacity utilization have a pronounced affect on businesses. However, industrial production and capacity utilization reports may also demonstrate the overall economic climate which is also of relevance to investing.

How to read and understand Federal Reserve reports

Each U.S. Federal Reserve Bank report may have a different format, topic, and measurement methodology. For example, one report may be a written statement of a Federal Reserve requirement whereas another may be a spreadsheet of historical numbers. Understanding and reading Federal Reserve reports involves 1) knowing what you’re looking for, 2) reading the measurement technique used in the report if any, 3) assessing the usefulness and applicability of the report to a specific investment and 4) accurately interpreting the data in terms of the investment(s). This process may take some time and practice but is an essential aspect of investment research.

To illustrate the above steps, consider the example of Mr. Bacchus who is interested in investing in Bank of America but is not sure whether or not that is a good idea. As part of his investment research Mr. Bacchus decides to study Federal Reserve reports to help with his investment decision. He wants to find out 1) if the bank has good future earnings prospects, 2) what the business and regulatory climate in which the bank will operate is and 3) information on the banks customers in terms of cyclical economic trends.

To find out this items Mr. Bacchus visits the Surveys & Reports section of the Federal Reserve website in addition to the Banking information and regulation section. Within these sections he determines some reports are more useful than others and decides to read the latest Bank holding Performance Report for Bank of America Corporation. This report gives Mr. Bacchus a wealth of information in 27 pages with which he determines the data is mostly quantitative and includes financial statements, performance ratios, derivatives and off balance sheet transactions, loan data and more.

Mr. Bacchus has now achieved steps 1-3 and must now complete step 4 and accurately interpret the data. Mr. Bacchus decides to focus on Derivatives and Off-Balance Sheet Transactions. Bacchus discovers that off balance sheet loans made by the bank are the lowest level in 4 consecutive years, and interest rate swaps are the highest in 4 years.

From this information Mr. Bacchus determines Bank of America Corporation is heavily hedging against the performance of its non-swap revenue cash flow indicating the bank may fear inadequate performance of other banking products. Since off balance sheet loans are at a 4 year low this helps validate Mr. Bacchus’ belief and leads him to suspect the bank is pursuing a more conservative and defensive posture than aggressive growth approach.

Whether or not Mr. Bacchus’ interpretation is correct and how he applies his understanding of the report to his investment decision is Mr. Bacchus’ concern; what he has done however, is locate, obtain, distinguish and interpret a Federal Reserve report.

How Do Fed Rate Cuts Affect Fixed Deposit Rates?

Federal reserve rate cuts impact fixed deposit rates because the cost of obtaining capital becomes cheaper for banks. Since the Federal Reserve Bank lends large amounts of money to banks, when they lower interest rates it becomes more cost effective for those banks to lower interest rates on consumer deposits since the bank's and/or financial institution's demand for money declines.

Deposits made to banks from consumers and/or non-financial businesses are fixed or variable. In the case of fixed deposit items such as certificates of deposit, money market funds, savings accounts and club accounts, changes in rates set by the Federal Reserve impact the interest yielded from such accounts.

How the Federal Reserve Bank changes interest rates

Generally, when the economy is growing well, interest rates rise making the acquisition of capital more expensive. The reason for this is the growing economy makes use of more capital than a recessionary economy hence the increase in demand. Since cost and demand are related via the economic principle of supply and demand, cost of deposits rises due to a greater need for capital in the economy. Inversely, when the economy is not growing fast or experiencing negative growth, the Federal reserve often makes it cheaper for financial institutions to acquire capital. It does this to help stimulate economic growth and does so through a decision making process carried out via the Federal Reserve board.

Different types of Federal Reserve interest rates

The federal reserve has a number of different lending rates including 1) the prime rate, 2) the federal reserve overnight interest rate, 3) Federal funds rate 4) Money Market Investor Funding Facility (MMIFF), and the indirect cost of financing T-Bills i.e. U.S. Government Treasury notes. According to bankrate.com, when the federal reserve funds prime rate is adjusted, the affect on the market includes changes to a wide range of accounts because the amount it costs financial institutions to borrow is affected as mentioned above. Changes to these Federal reserve derived lending rates impact fixed deposit rates.

Although the secondary market for T-bills can affect interest rates on these high denomination securities, the affect on bank borrowing costs via fixed deposit rates is not as direct as the over federal funds rate i.e. the cost of inter-bank borrowing. This is so as not all U.S. banks necessarily capitalize via re-lending borrowed funds to the Government via Treasury securities. However, if market conditions and the economy are weak, and the prime rate is lower than the T-bill rate, banks and financial institutions could yield a safe profit via borrowing using the prime rate and lending using the T-bill rate.

Affect of interest rate changes on fixed deposit rates

Since the Federal reserve bank, although a privately owned institution, is in effect a national central bank, it has significant influence on the availability of capital within the United States' financial markets, and financial system. Simply put, when the banks' bank lends at a lower cost, banks don't need to borrow from consumers quite so much.

Three sources of capital for financial institutions are 1) the Federal Reserve bank 2) other banks and/or corporations and 3) the consumer market. Banks and financial institutions are businesses and therefore often borrow at the lowest cost and lend at higher costs. Thus, when the fed lowers interest rates, whether they be the prime, federal funds rate or other sources of fed influence such as via MMIFF financing, the cost to banks becomes lower with the affect of a lower interest rate on consumer accounts.

Summary

To summarize, the Federal Reserve bank is a privately owned, national central bank for the United States of America. Such being the case, the federal reserve bank lends money in large amounts and sets important interest rates for its funds and that of U.S. banks. When rates are changed, this affects the cost of capitalization for financial institutions such as banks, credit unions, savings and loans institutions such as mortgage lenders. (www.federalreserveeducation.org)

The Federal Reserve bank arrive at interest rate changes through the Federal Reserve Board and change rates with the goals of facilitation economic functionality. When rates are changed, the borrowing costs of financial institutions changes making availability of capital greater, less or the same as previous rates. These changes affect the cost of liquidity for financial institutions, and therefore affect fixed deposit rates because financial instruments funded through fixed deposit rates are also a source of capital for financial institutions.

Sources:

1. http://www.federalreserveeducation.org/fed101/policy/basics.htm
2. http://www.federalreserveeducation.org/fed101/services/index.cfm
3. http://www.bankrate.com/brm/ratewatch/leading-rates.asp
4. http://en.wikipedia.org/wiki/Treasury_security
5. http://www.investorwords.com/3837/prime_rate.html
6. http://www.federalreserve.gov/monetarypolicy/mmiff.htm
7. http://tinyurl.com/4ev3sw8