How banks and the Federal reserve / central bank works

On US banks

  • they pay interest on deposits from customers and either borrow out the money to lenses or purchase short term US treasury . The spread between deposit interest rate paid to customers and US treasury yield/loan interest rate charged to lender is their profit
  • they charge lenders interest above long term treasury yield rate and finance the loan through either their own deposits or from borrowing
  • US Banks with deposits above USD122.3million needs to meet minimum reserve requirements of 10% imposed by the Federal reserve as of 2018

Meeting minimum reserve requirements

  • Borrow from Federal Fund Rate based on central bank interest rates
    • Used within US economy
    • rates are higher
    • hassle free
    • The federal funds rate is set in U.S. dollars and
    • charged on overnight loans.
    • The fed funds rate is the interest rate at which commercial banks in the US lend reserves to one another on an overnight basis
  • London Interbank Offered Rate (LIBOR) –
    • Used internationally
    • Borrow from other banks
    • rates are lower based on global supply and demand equilibrium
    • based on USD, EURO, Sterling, Swiss Franc, Yen
    • Quotations:
      • overnight, one week, and
      • one, two, three, six, and 12 months.

Federal reserve debt structure

  • US treasury bills:
    • short term maturity at one year or less.
    • Sold at discount
    • paid fully at maturity
  • US treasury notes:
    • 1 year to 9 years maturity
    • Sold at face value
    • pays fixed interest rates every six months.
    • Sold auction style.
  • US treasury bonds:
    • 10 years to 30 years maturity.
    • Sold at face value and
    • pays fixed interest rates every six months .
    • The original vehicle.
    • Registered to single owner and cannot be resold.

Federal Interest rate hike

  • Long term interest rate tend to react faster to hikes then short term interest rates
  • Long term Federal interest rates are used as benchmarks by banks to determine interest to charge lenders.
  • To prevent hyper inflation (price stability) after all employable people within the country have been employed into the economy.

Understanding the yield curve

  • Interest rates are considered the cost of money
  • The Federal reserve only manipulates the overnight interest rate
  • Longer term interest rates are determine by demand and supply of money
  • The Federal reserve increases the overnight interest rate by reducing the supply of money in circulation. This is achieved by supplying more short term securities in the open market, .
  • The Federal reserve decreases the overnight interest rate by increasing the supply of money in circulation. This is achieved by buying up short term securities in the open market.
  • Long term interest rates are higher than short term interest rates because long term interest rates require you to endure greater interest-rate uncertainty as well as greater likelihood of government default

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