Question

3) If the Fed observes a downward sloping yield curve, what should they do with the federal funds rate? Why? What affect will their action have on the yield curve?

Answer 1

Federal Bank of US serves as the central bank in the US State. It serves as a controlling factor for regulating the financial activities. Such Financial activities includes the closely monitoring the monetary policy. The monetary policy related issues are always related to rate of money supply and the interest rates for the funds invested through the matured bonds which are purchased or sold in the Federal Bank. Let us discuss the situation of Federal Bank experiencing downward sloping yield curve and its effect on funds rate.

Rate of Federal funds depends upon the long-term and short-term interest rates. The short-term rate depends on the cash reserve ratio of the commercial banks maintaining with the Federal Bank. If the rate of yield diminishes then the curve will move to downward direction. This is also witness the situation when long-term interest rates fetches low profit margin. But the Long-term interest rate are mainly determined by the market forces.

The following factors are the reason for the reflecting negative action on the yield curve. If the federal bank predicts about huge increase in the rate of inflation in future, automatically interest rate will reduce in order to increase the purchasing power of the people for the particular period unless the inflation rate are kept in stable level. But in contrary, when the money supply increases beyond the equilibrium level, it will again cause the inflation to rose at high level. So federal bank again cut short the interest rate. The Treasury bills are purchased by the Federal bank when money supply increases leads to decrease in inflation rate.