Krugman asks a question and so do I.

[edhopper]

In his blog today Paul Krugman asks:
The target Fed funds rate is now 2.25%. Everyone expects it to be reduced further; Citi economists predict that it will be down to 1% by mid-year.
But I have a possibly naive question: can the Fed really cut the Fed funds rate that far? I don’t mean “can” in the sense that other concerns will give them pause; I mean literally — does the Fed really have that ability?
http://krugman.blogs.nytimes.com/2008/03/20/fed-funds-question-seriously-wonkish-and-possibly-dumb-too/#comment-29874

I ask:
The other question is that this Government survives on the debt it accumulates by auctioning bonds. As the Fed lowers and our dollar falls, what will happen if the market for our bonds dry up like the Auction Bonds did last month. As that was a market that was also supposed to always be liquid, I don't see why the Treasury market could not also freeze.

[Fredda Weinberg]

1. Faith in US obligations. A modern phenom that yes, could collapse

Should it keep you up @ night? ... probably not. But theoretically, you are correct - any market can be made dysfunctional.

[The_Casual_Observer]

2. The working person/saver is defeated. Money market interest

is below inflation, & mutual funds are for shit producing loss after loss. We're all slaves now.

[shireen]

3. i'm pretty bummed out about it too ...

for the first time. i've accumulated some modest savings, put it in a MM with good interest rate, only to watch the interest rate plummet. People who have tried to be responsible with their money are being penalized. I'm very angry.

[abelenkpe]

6. huh, you noticed that too?

I wonder when more people will notice. If I'm not getting anywhere saving money, and my retirement and kids college funds are actually begining to lose ground how am I ever supposed to be able to retire or send my kids to school? How is that not servitude. I'm pretty upset about it all. And every plan I see the government proposing or enacting seems geared toward bailing out the financial instituions while punishing workers and savers. Or am I missing something here?

[Clear Blue Sky]

4. Maybe it goes negative and we pay banks to borrow our money...

[Jim__]

5. I'm not really following Krugman.

I'm not seeing the relationship between the Fed Funds rate and the Treasuries rate.

I know that when the Fed wants to lower interest rates, it buys Treasuries from the banks which increases the overall money supply. Also, if a bank is short on reserves, it tends to borrow money from another bank at the Fed Funds rate. But, why does the Treasuries rate prop up the Fed Funds rate?

Is it that if the Fed Funds rate is higher than the interest rate on Treasuries, the bank is better off holding on to its Treasuries as a reserve than borrowing at the Fed Funds rate?

Or, is it that when a bank needs reserves, the interest rate on Treasuries is a little kick over the cash it has in reserve, so it will buy Treasuries to prop up its reserves rather than borrow Fed Funds?

Or, is there some other relationship that I'm not seeing?

[uberllama42]

7. In 1996 Japan's benchmark rate hit zero

but they were using the discount rate as their primary policy tool at the time. The Bank of Japan sets that by fiat rather than through open market operations. I never considered what the effective minimum is for the Fed funds rate. That's a good question.

I'm not sure what would happen if the Treasury market locked up. My semi-educated guess is that the government would have to resort to seigniorage, printing money to meet its costs. Judging by the amount of debt this country has, my conjecture is that this would result in a really bad hyperinflation. Unless I'm totally wrong, now might be a good time to start buying Euros.

[edhopper]

8. Loos like

I picked the wrong time to quit drinking.

[upi402]

12. Is that the "gold standard" forex instrument now? What about gold?

I was thinkng gold would be imune to lunatic leaders exploiting their states. ie: Canada, Australia, England when under Tony B, Thailand when under Taksin, Iran under I'm-a-DinnerJacket, Saudi Arabia, ad infinitum...

I really don't know what to do anymore.

[AdHocSolver]

9. I may be all wrong, but I have to throw in my two cents worth.

My understanding is that the Fed funds rate sets the amount of interest that the banks pay depositors on their savings accounts amd money market accounts. By lowering that rate, the banks can charge borrowers including credit card holders whatever they want and pay depositors practically nothing for the use of their savings.

This is what Greenspan did when he was head of the Fed. Not only did this increase bank profits at the expense of depositors, but it pushed people to take their money out of insured savings (from which they were getting practically nothing) and speculate in the stock market. Savers throwering their assets at the stock market pushed the stock prices up ("price inflation") and formed the bubble at which time the insiders sold out making huge capital gains profits, leaving the rest of the investors with a lot of worthless (and uninsured) paper.

My understanding of Treasury notes is that they work like bonds. When you buy a bond, you pay less than face value and when the bond is due, you receive the face value when you redeem it. The difference between face value that you receive, and what you paid to buy the bond, is the interst you made.

So, if you buy a $100.00 bond for $90.00, you receive $10.00 in interest and so made approximately 10 percent in interest. (Actually, the percentage figure varies depending on whether you purchased the original bond or you bought it later on from an earlier purchaser. I don't know the calculations, but the concept is the same.)
If you buy the bond later than its issuance date from the original purchaser, and you pay her $95.00, then when you redeem the bond, you will receive the $100.00 or $5.00 more than you spent. You will have earned 5 percent interest.

The Fed can cut the rate of a $100.00 T-note to 1 percent merely by purchasing it for $99.00. It can make the T-note rate negative by paying MORE for it than the face value. For example, if the Fed pays $105.00 for a T-note with a face value of $100.00, then the rate of return is negative 5 percent.

Why would the Fed do this? It is, in effect, giving the money to the banks for free. This is one way to prop up the banks if they are in deep trouble.

[Hannah Bell]

10. i think something similar happened in japan to "encourage" people to take savings out of post office

accounts. though i don't really understand it well. i do know that a japanese friend had his mom take out savings because of the low po rates - then lost big chunks of it for her.

[A HERETIC I AM]

11. Yes, you're wrong. And your two cents is over priced.

My understanding is that the Fed funds rate sets the amount of interest that the banks pay depositors on their savings accounts and money market accounts.

Unfortunately, your understanding is incorrect. The Fed Funds rate is the target rate of interest banks charge each other to borrow the balances held at the various Federal Reserve banks and these loans are usually overnight. The rate of interest paid to depositors on savings accounts is related indirectly to this rate, but it is not "set" by it. A bank is free to pay any rate of interest it chooses to a savings account. Money Market funds are a completely different animal altogether. A money market fund will have in its portfolio various types of securities, from CD's to short term commercial paper to long term senior debt, but the paper is held for a very short term, usually less than 90 days. Go to the website of any Mutual Fund family you can think of, look for their Money Market fund and find the link to their prospectus or their annual report. You'll find an entire list of holdings. I heartily encourage you to do this. Study it carefully. Here, I'll help. Scroll down to page 7 for the beginning of the list of holdings.
http://en.wikipedia.org/wiki/Federal_funds_rate
http://www.sec.gov/answers/mfmmkt.htm

My understanding of Treasury notes is that they work like bonds.

They don't just "work like bonds", they ARE bonds.

When you buy a bond, you pay less than face value and when the bond is due, you receive the face value when you redeem it.

Not always. With very few exceptions, bonds have a "par" value of $1,000. You could pay par for the bond, you could buy it at a discount or you could pay a premium for it. By the way, the proper terminology for that point at which you receive face value is "Mature" not "Due". Bonds mature at par. Full stop. The only circumstance when this is not the case is if a bond is called or if there is a default. Even with a callable bond, most are called at par, but regardless of how much it is callable at, this is specifically spelled out in the terms of the original bond issuance. (You DO know what I mean by a "callable" bond, don't you?)

The difference between face value that you receive, and what you paid to buy the bond, is the interest you made.

What you are referring to here are a specific type of bond known as a "Zero Coupon". One that is sold at a discount and matures at par. T-Notes are not Zero Coupon bonds.

So, if you buy a $100.00 bond for $90.00, you receive $10.00 in interest and so made approximately 10 percent in interest. (Actually, the percentage figure varies depending on whether you purchased the original bond or you bought it later on from an earlier purchaser. I don't know the calculations, but the concept is the same.)

Wrong. The percentage figure does not vary because you were an original purchaser or bought it on the secondary market ("earlier purchaser"). What can vary is the yield and that is a mathematical function of interest over price.

Here are the calculations and the concept is NOT the same.

The formula for determining the current yield of a bond is:

Annual Income
Market price

The formula for determining the yield to maturity of a discount bond is 

Annual Income + Annual Capital Gain
purchase price + redemption price/2

The formula for determining the yield to maturity of a premium bond is 

Annual Income - Annual Capital Loss
purchase price + redemption price/2

Yield and Interest or "coupon rate" are two different things. Coupon rate never changes. Yield can fluctuate all the time because it is affected by the market price of a bond. When the market price of a bond is bid up, yield falls. When the market price of a bond is bid down, yield rises.

The Fed can cut the rate of a $100.00 T-note to 1 percent merely by purchasing it for $99.00. It can make the T-note rate negative by paying MORE for it than the face value. For example, if the Fed pays $105.00 for a T-note with a face value of $100.00, then the rate of return is negative 5 percent.

Bullshit. The Federal Reserve can NOT "cut the rate" of a Treasury Note "Merely by purchasing" it at a particular price. The United States Treasury and the Federal Reserve are TWO DIFFERENT ENTITIES and the Fed has to buy Treasuries in exactly the same fashion as anyone else, either at the auctions run by the Treasury on a regular basis or on the secondary market.

Why would the Fed do this? It is, in effect, giving the money to the banks for free. This is one way to prop up the banks if they are in deep trouble.

More bullshit. It is clear based on this post of yours and the ones you made in this thread that you lack an understanding of how bonds work, how capital is created and how the Federal Reserve manages and controls the money supply. What truly slays me is that you stated "My aim is to educate the economics-challenged"! Yeah. Right. Read up on Open Market Operations before you try and "educate" anymore of the "economics challenged".

Include yourself in that group

[upi402]

13. Journeyman work. Thanks for the info/education

Yeah, I jumped the track on the 'overnight' rate likened to savers' rates. My savings account pays puny rates, and seems unrelated to anything the OMBC suggests.
I'd like to know what percentage banks can borrow in relation to the money they actually hold.
If I recall correctly- the reserve ratio is 20%. Or has that been reduced to 10% now?

It all seems like a Ponzi scheme to me, especially considering fiat currency;
http://en.wikipedia.org/wiki/Fiat_currency

[A HERETIC I AM]

14. At the moment, the reserve percentage is 10%

According to this Wikipedia entry the United States has not had as dramatic a swing in, and actually has higher Reserve Ratio regulations than a number of other major democratic nations with open markets.

A table on that page shows a comparison of the change in Reserve Ratios over time regarding the United States and 3 other major countries. Reproduced here;

Country 	1968 	1978 	1988 	1998
United Kingdom 	20.5 	15.9 	5.0 	3.1
Turkey 	        58.3 	62.7   30.8    18.0
Germany 	19.0 	19.3   17.2    11.9
United States 	12.3 	10.1 	8.5    10.3

Here is an article on this subject from the New York Fed's web site.

This article makes a point that is interesting and I think, rather vital;

The Federal Reserve requires banks and other depository institutions to hold a minimum level of reserves against their liabilities. Currently, the marginal reserve requirement equals 10 percent of a bank's demand and checking deposits. Banks can meet this requirement with vault cash and with balances in their Federal Reserve accounts. Neither of these assets earns interest, however, so banks have an incentive to minimize their holdings.

Since the beginning of the last decade, required reserve balances have fallen dramatically. The decline stems in part from regulatory action: the Federal Reserve eliminated reserve requirements on large time deposits in 1990 and lowered the requirements on transaction accounts in 1992. But a far more important source of the decline in required reserves has been the growth of sweep accounts (chart). In the most common form of sweeping, funds in bank customers' retail checking accounts are shifted overnight into savings accounts exempt from reserve requirements and then returned to customers' checking accounts the next business day. Largely as a result of this practice, today only 30 percent of banks are bound by a reserve balance requirement (chart).

A stack of 100,000, one hundred dollar bills locked in a vault will be exactly the same number tomorrow. The incentive to loan it for VERY short periods is that it can earn interest. Since the risk is low, the yield is low to the point of being a very small percentage. But even if the interest earned on such a short loan would be tiny, the interest payment can get rather substantial with larger sums. Two basis points (that's two one hundredths of a percent or 0.02%) on ten million is $200,000

Fractional Reserve Banking policies and "Fiat" money are not the Boogymen many DU'rs seem to think they are.

Edited for clarity.