FIN 366 Week 2 The Federal Reserve and Monetary Policy Example

How the Fed's Rate Cycle Reached a Community Bank's Margin: Policy Tools, the Transmission of Rate Changes and Deposit Pricing From 2022 Onward

[Student Name]

University of Phoenix

FIN/366: Financial Institutions

Week 2 Assignment

[Instructor Name]

[Date]

The bank and its figures are composites written for a model paper; policy facts and research findings come from the sources listed and are stated generally.

The community bank from last week's analysis earns most of its income from the spread between what it earns on loans and bonds and what it pays on deposits. When the Federal Reserve raised its policy rate in 2022 and 2023, and later began to lower it, that spread moved in ways the bank's board did not expect. The Federal Reserve never sets a bank's loan or deposit rates, yet every decision it makes shows up in those rates within weeks or months. This paper explains how.

The Fed's Structure and Goals

The Federal Reserve System consists of the Board of Governors in Washington, twelve regional Reserve Banks and the Federal Open Market Committee, which sets monetary policy. Congress gave the Fed a dual mandate: maximum employment and stable prices, which the Fed interprets as inflation of 2% over time. The Fed is independent within government, so its decisions do not require approval by Congress or the President, an arrangement intended to protect long-term price stability from short-term political pressure (Mishkin, 2022).

The Tools

The committee sets a target range for the federal funds rate, the rate banks charge each other for overnight loans. In today's system, with ample reserves in the banking system, the Fed keeps the market rate within its range mainly by setting administered rates. It pays interest on reserve balances that banks hold at the Fed, which sets a floor, since banks will not lend reserves for less than the Fed pays them. It offers an overnight reverse repurchase facility to money market funds and others, which supports the floor for nonbanks. It lends to banks at the discount window, whose rate acts as a ceiling. Open market operations, buying and selling Treasury securities, remain important for managing the size of the Fed's balance sheet rather than for daily rate control.

The Fed also uses its balance sheet. During crises it has bought large amounts of Treasury and mortgage-backed securities to lower long-term rates, and since 2022 it has reduced those holdings by allowing securities to mature without replacement, a process known as quantitative tightening.

The Recent Rate Cycle

In early 2022, the federal funds target was near zero. With inflation running well above 2%, the committee raised the target rapidly, reaching a range of 5.25% to 5.50% in 2023, the highest in more than two decades. As inflation eased, the committee began lowering the range in late 2024. The Fed also shrank its balance sheet throughout much of this period.

How the Cycle Reached the Bank

The bank's variable-rate commercial loans reset with the prime rate, which moves with the federal funds rate, so their yields rose quickly. Its fixed-rate mortgages and bonds did not reprice until they matured. On the funding side, the bank initially raised deposit rates slowly. In the language of banking, its deposit beta, the share of market rate increases passed to depositors, was low at first, about 0.2 in the first year, because depositors did not move money quickly. The bank's net interest margin widened from 3.1% to 3.5%.

As rates stayed high, depositors moved money to higher-yielding certificates of deposit and money market funds, and competition forced the bank to raise rates faster. Its cumulative deposit beta rose to about 0.45, and its margin fell back to about 3.0% by 2024, lower than before, because its fixed-rate assets had not yet repriced while its deposit costs had. When the Fed began cutting, the bank's variable loan yields fell immediately, but it could lower certificate rates only as they matured, squeezing its margin briefly again.

The Transmission Channels

The bank's experience illustrates the interest rate channel of transmission: policy changes short-term rates, which affect borrowing costs and spending. Bernanke and Blinder (1992) found evidence that the federal funds rate is a good indicator of monetary policy and that tightening reduces bank deposits and, with a lag, bank lending, which is the credit channel. The bank saw this directly: as its funding became more expensive, it tightened lending standards for commercial real estate. Policy also works through asset prices, lowering bond and stock values when rates rise, and through exchange rates.

Reading the Fed With a Policy Rule

Taylor (1993) proposed a simple rule describing how the federal funds rate responds to inflation and the output gap: the rate rises more than one for one with inflation above target and rises when output exceeds its potential. The rule does not dictate decisions, but it helps banks anticipate them. In 2021, the rule suggested rates well above the actual target, consistent with the view that the Fed began tightening late; by 2024 the gap had closed.

Liquidity and the Fed's Backstop

The cycle also tested liquidity. When several banks failed in the spring of 2023, the Fed opened a temporary term funding program that lent to banks against high-quality securities valued at par, easing pressure on banks with unrealized losses. The community bank did not borrow, but it pledged collateral at the discount window so that it could borrow quickly if needed. The Fed's role as lender of last resort is part of monetary policy's toolkit and a reason banks keep eligible collateral ready.

Lessons for the Bank

The bank's board learned three lessons: deposit betas rise the longer rates stay high, so early margin gains are temporary; fixed-rate assets make margins slow to recover; and the bank should model margins under several rate paths each quarter rather than assume the current rate persists. It now uses rate scenarios with different deposit betas in its budget.

Conclusion

The Federal Reserve sets short-term rates through administered rates and manages longer rates partly through its balance sheet. The cycle that began in 2022 reached the community bank through variable loan yields, slower-moving deposit costs and eventually competitive pressure on deposits, widening and then compressing its margin. Understanding deposit betas and policy rules helps the bank plan for the next cycle.

References

Bernanke, B. S., & Blinder, A. S. (1992). The federal funds rate and the channels of monetary transmission. The American Economic Review, 82(4), 901-921.

Mishkin, F. S. (2022). The economics of money, banking, and financial markets (13th ed.). Pearson.

Taylor, J. B. (1993). Discretion versus policy rules in practice. Carnegie-Rochester Conference Series on Public Policy, 39, 195-214. https://doi.org/10.1016/0167-2231(93)90009-L