Something funny is going on with the Fed funds rate, but everyone is so engrossed with the auto industry and other dramas that few have noticed.
This long-obscure interest rate historically has been an important financial-market barometer, but its readings over the past two months are erratic, to say the least. Either the Fed has abandoned what it says is its principal policy tool, or that tool has become impotent.
Let’s start with some background. Commercial banks are financial intermediaries, accepting deposits and making loans. To protect depositors against loss, banks are not allowed to lend out all the money they get as deposits. Legally, a fraction must be held in reserve. And banks may choose to hold more money in reserve than the legal minimums.
These reserves may be held in the form of “vault cash” in the bank itself. But most are held in the bank’s account at its Federal Reserve District Bank. (These reserve accounts at the Fed also are used in check clearing, but that is another column.)
Historically, the Fed did not pay any interest on banks’ reserve accounts. Money not loaned out earns no interest. So banks normally keep their reserve accounts at or just above required minimums.
But their deposits vary and so do their Fed reserve accounts, often depending on how many checks are presented for payment. On any given day, a bank may be short of “Fed funds” or have extra.
Banks can lend among themselves. One with excess Fed funds can lend to another that is short. Such loans are the shortest possible, from one business day to the next.
The interest rate depends on supply and demand — on the relative amounts of Fed funds offered for overnight loan versus the amounts desired by banks that need them. There is one important qualification, however. The Fed can alter the money supply in a way that changes the quantity of total reserves in the banking system.
Thus, the interest rate on these overnight loans of reserves is the indicator that the Fed uses to guide its changes in the money supply. When the Federal Open Market Committee meets, as it will next week, and announces its Fed funds target, it is saying it will change the money supply however necessary to keep overnight interest rates at this target. It is like a driver pressing down and letting up on the gas pedal to try and keep the speedometer needle steady at 30 miles per hour.
Fed changes in the money supply affect other interest rates too, especially short-term ones like the London Interbank Offered Rate (LIBOR), often used as an index for other loans, and those on Treasury bills.
Historically, the open-market desk at the New York Federal Reserve, the entity that actually changes the money supply, took pride that the actual Fed funds rate banks charged each other never varied by more than a few hundredths of 1 percent from the announced target. If the target was 5 percent, the effective rate might be 4.96 percent on one day and 5.03 percent another, but it was always close to the target.
That broke down in August 2007, when the Fed, the European Central Bank and the Bank of England pumped large amounts of reserves into their financial systems to ward off a freeze-up of the commercial paper market. This pushed the actual Fed Funds rate as much as 0.75 percent below its target.
The FOMC began to stair-step the target down in September 2007, in nine separate cuts that brought it to 1 percent at the end of October 2008. Many analysts expect it will be cut further, perhaps to zero, at next week’s meeting. But wider swings in actual rates around the target that began in 2007 have persisted.
Some such spastic fluctuations reflected news like the failure of Bear Stearns in March. In mid-September, as Lehman Brothers failed and the government pumped extraordinary amounts of money into insurer AIG, the swings looked like a seismograph needle during an earthquake.
However, they were always around the mean of the official target rate, at least until recently. Since the cuts to 1.5 percent and 1 percent announced on Oct. 7 and 28, respectively, the effective rate has stayed below the target. In the six weeks that the target has been at 1 percent, the effective rate has averaged less than 0.4 percent.
This reflects a couple of factors. First, banks are extraordinarily wary of making loans, preferring to sit on excess reserves earning virtually no return rather than make loans. Secondly, the other government actions, both by the Fed and by the Treasury, to pump liquidity into the economy may be overwhelming the mundane efforts of the Open-Market Desk to maintain the target rate.
There is a possibility it reflects a conscious Fed decision to undershoot the official target, knowing the target is likely to be lowered at the Dec. 15-16 meeting anyway. If so, this is poor policy. If the Fed says it is going to keep an interest rate at a stated level, it should do so. If it doesn’t, it sends the message that its primary policy tool — increasing and decreasing the money supply by buying or selling bonds — is no longer effective.
© 2008 Edward Lotterman
Chanarambie Consulting, Inc.