One thing that had never been clear to me was how Fed's control over the interest rate actually works. I have always wondered which interest rate they were talking about, and how they actually execute a change in the interest rate.
First of all, "interest rate" here refers to Fed Funds Market interest rate. It is basically an interbank interest rate within Fed, where financial institutions are required to deposit a reserve. It is similar to LIBOR, but the major difference is that Fed Funds Rate is targeted by a government entity Fed (specifically Federal Open Market Committee), whereas LIBOR is determined by the free market of supply-demand.
Why is this rate important? To begin with, there are several ways a bank can borrow money from the government; fed funds market and treasury bills, which account for "government loans to banks" with the duration of less than one year. While this treasury bills are sold through an auction (some through non-competitive bids, but mostly competitive bids), their demand and its corresponding yield will be influenced, or determined, by fed funds rate. Subsequently, as the treasury bills rate changes, the yield for treasury notes and bonds changes accordingly, based on the yield curve.
How is this yield curve determined? I remember learning this in an Econ class, but I have to revisit and fully understand the mechanics of it. One thing to note is that this would probably have an indirect impact on a bank's own yield curve model, and therefore Net Interest Margin and earnings.
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