The federal funds rate is the interest rate that depicts the tightness or ease in the banking system. Banks need reserved to extend credit, that is, to make loans and investments. When reserves are in short supply, banks may buy the excess reserves of other banks to cover their reserve requirements at the Federal Reserve. If the demand is greater than the supply of excess reserves, then the federal funds rate will rise. Conversely, if the supply of excess reserves is plentiful, then the fed funds rate will decline.

This rate is extremely important because the Federal Reserve controls the amount of reserves made available to the banking system, and through them, the level of short-term interest rates. For most all of the short-term money market, rates are based on the fed funds rate.

For the past several weeks, the money market and the bond market, have been anticipating that the 15 percent level of the fed funds rate would soon crack and that a rally would occur as other interest rates followed the funds rate down to lower levels. Dealers have been carrying alot of inventory in preparation for just such a market move. Dealers reasoned that inflation was falling, the economy was critical, unemployment was rising, bond calenders were fairly light, and once the fed funds rate fell, prices would soar.

Federal funds declined last week and everything happened as was expected. But a couple of problems arose that ruined the dealers strategy. First off, the funds rate fell to 13 percent, but then promptly rose. One-month certificates of deposit fell from 14 1/2 percent on the previous Friday to 14 percent on Wednesday. However, by late Thursday, the CD rate had risen again to 14.45 percent. This roller coaster movement was true of all money market rates.

Another significant problem was the lack of legitimate retail buyers of fixed-income securities. The four-year Treasury note issue, which had an average return of 14.05 percent, was purchased mainly by the dealer community. By the end of trading on Thursday, the new issue was selling below its original issue price.

The next three to four weeks is a period, for whatever reasons, that the M-1 money supply usually shows a large increase. This stirs up fears, that the fed, at worse, might tighten credit restraint, or at the least, will not ease credit and allow rates to decline. This became an increasingly worrisome factor as last week progressed. However, the most damaging factor to the market is the estimated $120 billion deficit in fiscal year 1983. In fact, to borrow some revealing numbers from the Schroder Report causes one to question the outlook for interest rates.

The Schroder Report assumes a deficit for fiscal year 1983 of $120 billion, plus off-budget financing of $20 billion, for a total financing need in FY '83 of $140 billion, to be raised through the sale of marketable debt. In order to finance this staggering sum, $40 billion may be raised by adding to the weekly Treasury bill auctions. This leaves $100 billion of new money to be raised by the coupon route. At the same time, in FY '83 $90 billion of already-outstanding Treasury coupon issues will mature and must be refinanced. This brings the total of coupon issues to $190 billion that must be sold by the Treasury in FY '83 to cover their debt needs. This is why the deficit is so important, especially when the administration is talking about a recovery in the second half of 1982. It means that when the private sectors' credit demands will be increasing, the Treasury will get their money first, at whatever rate necessary and the private sector be demned. This will force many corporations to spend their cash, to borrow from banks or to borrow through the short-term commercial paper market. All of these sources place a liquidity drain on the corporations and weakens their creditworthiness and ability to survive.

The municipal calender is building. Of importance to short-term buyers is the tentatively scheduled $3 billion New York State Tax Revenue Anticipation (TRANS) issue with four maturities coming due over the next 12 months. They should return somewhere between 8 percent and 8 1/2 percent.

The Treasury will offer a seven-year note on Wednesday. This issue will be available in minimums of $1,000. And good news for small investors, the Treasury will continue its policy of offering Treasury securities through the Federal Reserve banks and the U.S. Treasury in Washington, D.C., and without a fee. With the financing schedule facing them it makes good sense.