Sunday, January 10, 2016

Those 25 Basis Points

The U.S. GDP clocked in at $17.968 trillion last year—a right rather huge, indeed almost unthinkable number. But the business news throughout 2015 concerned agonizing reflections on whether or not the Federal Reserve would actually raise the Federal Funds Rate, and if yes, when and by how much. Let’s look at this for a moment.

The Federal Funds Rate (FFR) is the interest charged by the Fed to lend money to banks, usually for a short period of time. The banks borrowing this money then have more to lend. If the FFR rises, money gets more expensive; if it drops, money gets cheaper.

The Fed has a target rate for such lending. Until December 16 of last year, that target was a range from 0 to 25 basis points. What those are will be explained in due time. The range exists because Fed lending can vary in price between those two number. Last December the actual rate charged averaged between 13 and 15 basis points up to December 16. Then the Fed changed its target range to 25 to 50 basis points. In other words, the average of all lending had to fall somewhere at or between those numbers. Since the increase, the actual FFR rate has been around 36 basis points, thus significantly less than the maximum of 50. For a look at December results, see this table provided by the Federal Reserve Bank of New York (link).

So how much is that 25 point increase the Fed finally decided to institute? The best way to explain that is by reference to a percentage point. Everybody understands that a percent is one hundredth part of something. 1% of a dollar is a penny. Now each percent could also be divided by 100. In that case each percent would have 100 parts. And each of those parts would have a name. And that name is the Basis Point. So there are 100 basis points inside each penny.

Now just as a trillion is difficult to grasp (never mind nearly 18 of them) so also a basis point is quite invisible—a minute portion of a penny you might be able to scratch off with a very hard knife. 25 basis points are, therefore, a quarter of a penny.

When we increase the quantity of money, those basis point start having meaning. On $100 it’s a quarter, on $1,000 is $2.50, on 10,000 it’s $25. But, of course, when you borrow millions daily, it actually becomes quite visible. What about 25 basis points of that $18 billion? Well, on that amount those basis points produce a charge of $45 million. But, when I think about it, that won’t even buy me a single nuclear submarine; we’re talking billions of dollars per unit there…

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