Fed Funds Become a Victim of Unintended Consequences

by: Zubin Jelveh

On Wednesday, I wondered why the effective fed funds rate was trading below the interest rate now being paid by the Fed for required reserves. Theoretically, the rate paid on reserves should be a floor for the market rate for fed funds. That's because banks should always choose to keep their reserves at the Fed and earn the risk-free reserve rate rather than expose themselves to counterparty risk at rates less than the one being offered by the Fed.

Over at Econbrowser, James Hamilton provides an interesting and plausible theory for why effective fed funds are trading below the reserve rate. I recommend reading the whole thing, but the short version is this: GSEs also have accounts with the Fed but they don't earn interest on their reserves, so banks could be performing a carry trade: borrowing reserves from the GSEs at lower rates and depositing them at the Fed to earn the higher reserve rate. But since the FDIC is now charging 75 basis points for insuring borrowed reserves -- which are unsecured -- it wouldn't make sense for banks to borrow at overly high rates, otherwise, with the insurance costs included, they would be paying more to borrow than they're earning on reserves. So that means if the fed funds market is dominated by lending from GSEs then the gap between the effective rate and the reserve rate should be around 75 basis points. Let's look at the current situation.

The fed funds rate is at 1 percent and since insuring borrowed reserves costs 75 basis points, banks wouldn't want to pay more than 25 basis points to GSEs for borrowing reserves. And guess what? Over the last week the effective fed funds rate averaged 23 basis points.

Hamilton thinks there are a couple of problems with this dynamic:

First, fed funds futures contracts, which are based on the average effective rate rather than the target over a given month, are primarily an indicator of how these institutional factors play out -- how much the effective rate differs from the target -- and signal little or nothing about future prospects for the target. Second, the target itself has become largely irrelevant as an instrument of monetary policy, and discussions of "will the Fed cut further" and the "zero interest rate lower bound" are off the mark. There's surely no benefit whatever to trying to achieve an even lower value for the effective fed funds rate. On the contrary, what we would really like to see at the moment is an increase in the short-term T-bill rate and traded fed funds rate, the current low rates being symptomatic of a greatly depressed economy, high risk premia, and prospect for deflation.

What we need is some near-term inflation, for which the relevant instrument is not the fed funds rate but instead quantitative expansion of the Fed's balance sheet.