Skip to main content
The FRED® Blog

Posts tagged with: "FEDFUNDS"

View this series on FRED

Gauging returns and risk in the bond market

The term premium, risk premium, and yield curve

Investors in the corporate bond market routinely make decisions about which bonds to purchase; and they look at, among other things, the rates of return of those bonds. One way of computing a bond’s rate of return is to take into account all future streams of payments (interest coupons) as well as the difference between the price and the principal if the bond is held to maturity. This rate of return is known as the yield of the bond.

The yield on a security allows investors to decide whether to accept the riskiness and the cost of holding that security for an extended period or to invest in a safer, shorter-term bond. In other words, yields capture both a risk premium (the compensation for uncertainty in the streams of payments) and a term premium (the compensation for a longer delay in receiving payments). We can use FRED’s data and graphing tools to produce measures of both the risk premium and the term premium and see how these measures have evolved over time.

The first graph shows three interest rates: the 5-year yield on investment-grade corporate bonds, the 5-year Treasury rate, and the federal funds rate. These three interest rates provide us with information on the returns to a 5-year corporate bond, a 5-year Treasury bond, and an overnight bond. The graph shows that the federal funds rate is typically lower than the other two rates: Lenders require additional compensation to lend for longer periods (5 years in this case). Since both Treasury bonds and federal funds are extremely safe assets, the risk premium is negligible and any difference between the two arises from the term premium.

Mathematically, the term premium is the difference between the Treasury rate for a given maturity and the federal funds rate. The second graph plots the term premium since 1984. This indicator seems to be countercyclical—that is, it falls during expansions and rises during recessions. More interestingly, it tends to go negative right before a recession, and this is what people refer to when talking about a “yield curve inversion.”

As the first graph shows, the yield on 5-year corporate bonds exceeds the yield on 5-year Treasury bonds. Since these two groups of bonds have the same maturity, this difference cannot be explained by the term premium. Rather, it’s explained by the risk premium: the compensation lenders require to invest in a riskier asset (such as a corporate bond) as opposed to investing in a safer asset of equivalent maturity (such as a Treasury bond).

Mathematically, the risk premium is the difference between the yield on a risky bond and the yield on a Treasury bond of equivalent maturity. The third graph plots this difference. Again, this measure is countercyclical. See the prominent spike in 2008-09? The risk premium rose way above its historical average during the Great Recession following the Financial Crisis. If market participants anticipate an increase in risk, as they did in 2008, then the risk premium rises in response. Since the risk premium measures expectations of credit risk and default in the economy, it’s an important way to monitor markets to ascertain whether a downturn is expected in the near future.

How these graphs were created: For the first graph, search for and select the series “5-Year High Quality Market (HQM) Corporate Bond Spot Rate.” Use the “Add Line” option in the “Edit Graph” menu to search for and add the other two series: “5-Year Treasury Constant Maturity Rate” and “Effective Federal Funds Rate.” For the second graph, search for and select the series “5-Year Treasury Constant Maturity Rate.” Then use the “Edit Line 1” tab in the “Edit Graph” menu to add the series “Effective Federal Funds Rate” in the “Customize data” field. In the “Formula” box, type a-b. Repeat these steps for the third graph by searching for and selecting the series “5-Year HQM Corporate Bond Spot Rate” and the series “5-year Treasury Constant Maturity Rate.”

Suggested by Asha Bharadwaj and Miguel Faria-e-Castro.

View on FRED, series used in this post: FEDFUNDS, GS5, HQMCB5YR

Comovements in monetary policy

Revealing international correlations with FRED

Reporters and Fed watchers in the U.S. usually think about monetary policy in a domestic framework. But because business conditions, including commodity prices, are correlated internationally, central banks tend to move their policy rates up and down together and their inflation and interest rates tend to be correlated. FRED makes it easy to see these international comovements of macro and policy variables.

The first graph shows comovement in inflation rates from 1970 to the present for four economies: the U.S., Japan, the U.K., and the euro area. Inflation rose in the 1970s as central banks failed to combat the effects of commodity price increases on the general price level and inflation expectations became established.

Before the Financial Crisis of 2007-2009, almost all central banks in the developed world implemented monetary policy mainly by buying and selling short-term bonds to influence short-term interest rates or “policy rates.” The second graph shows the comovement in these policy rates from 1970 to the present for the Federal Reserve, the Bank of Japan, and the Bank of England: These central banks first hiked their policy rates in the 1979-1981 period to combat inflation and were then able to reduce those rates in the 1980s after inflation fell.

The second graph also shows that the Federal Reserve, the Bank of England, and the Bank of Japan lowered their short-term interest rates to zero during the Financial Crisis. To maintain price stability and continue to stimulate their economies, they turned to “unconventional” monetary policies that included buying long-term bonds to reduce long-term interest rates.

The value of the assets of central banks is one (albeit imperfect) way of measuring the monetary stimulus of unconventional policy. The third graph shows the assets of four central banks using an index for their values in 2008. The index value, rather than the value in each respective currency, allows a rough but easy comparison of the relative monetary stimulus. Central bank asset holdings have all increased greatly over the past decades. The Federal Reserve and the Bank of England had the first large responses in 2008-2009. The Bank of Japan began to accumulate assets in earnest starting in 2013. And the European Central Bank did likewise starting in 2015.

How these graphs were created: First graph: Search for “consumer price index for all urban consumers,” select the seasonally adjusted monthly version of the appropriate series, and click “Add to Graph.” From the “Edit Graph” panel’s “Add Line” tab, add the monthly versions of the three series “Consumer Price Index of All Items in Japan,” “Consumer Price Index of All Items in the United Kingdom,” and “Harmonized Index of Consumer Prices: All Items for Euro Area (19 Countries).” For each of these four lines, change the units to “Percent Change from Year Ago.” Lastly, change the start date to 1970-01-01.
Second graph: Search for “effective federal funds rate,” select the appropriate monthly series, and click “Add to Graph.” From the “Edit Graph” panel’s “Add Line” tab, add the monthly versions of the two series “Immediate Rates: Less than 24 hours: Central Bank Rates for Japan” and “Bank of England Policy Rate in the United Kingdom.” Lastly, change the start date to 1970-01-01.
Third graph: Search for “All Federal Reserve Banks: Total Assets,” select the appropriate series, and click “Add to Graph.” From the “Edit Graph” panel’s “Add Line” tab, add the three series “Bank of Japan: Total Assets for Japan,” “Total Central Bank Assets for United Kingdom,” and “Central Bank Assets for Euro Area (11-19 Countries).” For each of these four lines, change the units to “Index (Scale value to 100 for chosen date)” and select the date 2008-01-01. Lastly, change the start date to 2004-01-01.

Suggested by Chris Neely.

View on FRED, series used in this post: BOERUKM, CP0000EZ19M086NEST, CPIAUCSL, ECBASSETS, FEDFUNDS, GBRCPIALLMINMEI, IRSTCB01JPM156N, JPNASSETS, JPNCPIALLMINMEI, UKASSETS, WALCL

Paying interest on excess reserves

An additional policy tool for the Fed

Commercial banks must adhere to regulations, including so-called reserve requirements. That is, banks must hold a certain fraction of their deposits as cash in a Federal Reserve account; these are known as “required reserves.” Banks can choose to hold even more cash in those accounts than what the Federal Reserve requires; these are known as “excess reserves.”

The graph above shows that required reserves are quite stable and grow as a constant fraction of total deposits in the banking system. But excess reserves increased considerably in 2008, as the Fed expanded the money supply to finance unconventional monetary policy measures such as quantitative easing. As of May 2018, excess reserves are nearly $1.9 trillion, ten times more than required reserves.

In normal times, excess reserves aren’t profitable, as they don’t earn a return. Instead of holding cash as excess reserves, banks could lend those funds and earn interest. However, after the 2008 recession, the Federal Reserve started paying interest on excess reserves (IOER). By altering the incentives for commercial banks to extend loans or hold excess reserves, the Fed is able to use the IOER as an additional monetary policy tool.

The second graph plots the IOER along with the (effective) federal funds rate, the Fed’s main tool for conventional monetary policy. The federal funds rate can be thought of as the interest rate at which financial institutions make short-term loans to each other. Here, we see that the federal funds rate tracks the IOER very closely. When banks have excess liquidity or reserves, they can choose whether to lend those reserves to other banks (at the federal funds rate) or deposit them at the Fed (and earn the IOER). Banks aren’t willing to lend to each other if the federal funds rate is substantially lower than the IOER, and so the two rates move closely together.

How these graphs were created: For the first graph, search for and select “required reserves of depository institutions” and click “Add to Graph.” From the “Edit Graph” panel, choose “Add Line,” search for and select the monthly “excess reserves of depository institutions” series, and click “Add data series.” The first series is in billions of dollars; to change it to match the second series (in millions of dollars), select “Edit Lines”/”Edit Line 1” and add the formula a*1000. For the second graph, search for and select the monthly “effective federal funds rate” series. From the “Edit Graph” panel, choose “Add Line” and search for and select “interest rate on excess reserves.” Use the date range tool to set the start date in August 2008.

Suggested by Asha Bharadwaj and Miguel Faria-e-Castro.

View on FRED, series used in this post: EXCSRESNW, FEDFUNDS, IOER, REQRESNS


Subscribe to the FRED newsletter


Follow us

Back to Top