What's Happening to the Fed Funds?

Here are more, and better, explanations for the divergence between the effective fed funds rate and the target rate.

But to explain it well, I'll have to go back to the beginning.

Right around the time of Lehman's collapse in mid-September, the effective rate started to swing wildly above and below the Fed's target rate:

This phenomenon was chalked up to the massive amount of reserves the Fed was pumping into the banking system. The following chart shows excess reserves held by all eligible institutions. Between Sep. 10 and Nov. 5, excess reserves grew by 16,000 percent:

After the Emergency Economic Stabilization Act was passed in early October, the Fed then started to pay interest on the required and excess reserves held by eligible banks. The reason for this, as explained by the New York Fed, was that the immense volume of excess reserves had made it very hard for open market operations to have the desired effect of keeping the market and target rates close to one another. And, theoretically, paying interest on reserves would put a floor underneath the market rate. Here's the logic:

With the payment of interest on excess balances, market participants will have little incentive for arranging federal funds transactions at rates below the rate paid on excess. By helping set a floor on market rates in this way, payment of interest on excess balances will enhance the Desk's ability to keep the federal funds rate around the target for the federal funds rate.

So did that happen? Well, it depends on how you look at it. The following chart is the same as the first one above, but it includes the interest rates paid on required and excess reserves:

A cursory look seems to show that the excess rate hasn't acted as the promised floor. The first explanation for this anomaly came from Econbrowser's James Hamilton (and was repeated by me). Hamilton's theory had two parts, but one of them was invalidated by New N Economics' Rebecca Wilder, so I'll concentrate on the one that works.

There are some institutions, like GSEs, that are mandated to maintain reserves but who don't earn any interest on either required or excess reserves. The presence of GSEs allows eligible banks to perform a carry trade: borrow reserves at a low rate from the GSEs, and then earn the difference between the excess rate and the rate paid to the GSEs. That dynamic would put downward pressure on the effective fed funds rate.

Another way to look at this anomaly comes from Action Economics' Mike Englund who argues that there may not actually be one. For example, the average effective rate since the Fed started paying interest on reserves was 0.68 percent. The average excess rate over the same span was 0.70 percent. That's pretty close and if you look at the last chart again, the market rate does seem to dance around the excess rate until the Fed lowered the target in late-October. Englund tries to explain this last part away:

Note that there is a speculative component to holding excess reserves, as the excess reserve rate for the [reserve maintenance period] RMP is pegged to the "lowest" target in the period, which is not precisely known until the last day of the period. This might explain some "bets" of emergency Fed easing late in the RMP that would lower the excess rate for the entire period, and hence leave a rate that trades through most of the period below the excess reserve "floor."

(A reserve maintenance period is the two-week span used by the Fed to calculate each institution's average daily reserve holdings.)

But I'm not sure I buy this explanation. If Englund's assertion is really at work here, then traders were betting that the Fed would lower rates right after it had just cut them by 50 basis points. That doesn't seem likely.

The third view comes from Wilder. She attributes the fed funds miss to both GSEs and excess reserves, and she doesn't have kind words for the interest on reserves program:

It looks to me like the Fed's IOR rate is essentially meaningless as long as GSEs are trading federal funds. I bet that there will be an announcement going forward that will modify the IOR rules temporarily to include all firms that hold reserves with the Fed, not just the depository institutions covered under the Fed's umbrella.

The second part seems plausible, but it's not strictly the case that the interest on reserve rate is meaningless. The following chart shows the standard deviation in daily fed funds market rate moves:

Since the interest on reserves scheme was introduced, the fed funds market has become a lot less volatile. This all points back to fact that open market operations intended to keep the target and effective rates close to one another have been a bust, and that the interest on reserves scheme -- over the long run -- may be a more effective way of conducting monetary policy. And unless the Fed acts to boost the effective rate, the real monetary policy interest rate is a lot closer to zero than the one set by the FOMC.

(HT: Mark Thoma)

Comments

[jepittman:]

I have two comparatively simplistic observations concerning this. First a lower market funds rate widens the spread for lending banks (increases the opportunity cost) and second the rather higher target rate keeps borrowing costs otherwise higher since most lending rates are based on the target funds rate (e.g. the prime rate). Seems to me this would work to encourage banks to lend. Maybe this is why the fed tolerates it.

2008 Nov 11 12:57 PM

[User 295942:]

Is the "Y" axis of the second chart supposed to be billions? Fed report H.4.1 shows it as billions I believe.

2008 Nov 11 01:03 PM

[Owen:]

The Fed tries to control short term rates by having the NY Fed act as a market-maker in the overnight repo market. As any market maker can tell you, this works well when volumes are small compared to the MM's pool of liquidity, but falls apart once volumes exceed their short-term internal capital resources.

Daily balancing and weekly Bill auctions keep the NY Fed well supplied, but during a single day, a sudden inflow of tens of billions of securities tendered can easily shift the actual rate by several basis points away from the target rate. Remember, the Fed is a very large market participant, but it is just one among many other large players.

2008 Nov 11 02:43 PM

[User 265729:]

Paulson and Pelosi can throw the American taxpayer's money into this problem until they are blue in the face...

This is a *STRUCTURAL PROBLEM*

Nobody is buying cars... There is no DEMAND for cars... It is not unique to GM, Ford or Chrysler.. MB, BMW, Japanese makes... They are all in big trouble...

ALL of these companies have been living off of the DEMAND created by a housing bubble. Sure, it was nice to get that home equity loan to buy you giant SUV while your house's value is climbing 40 percent a year, but it ain't so anymore, now is it?

Paulson and Pelosi can spend our government (the American people) into bankruptcy and they are well on their way to doing it, but all of their efforts will not create demand that is NOT there. The demand will NOT be there like it was for a decade or more...

This is sorta like an economic Vietnam... Paulson and Pelosi are going to destroy the village to save it. They will throw $billions into these companies (all of them GE BAC WFC ETC) and the end game will be the same. Their government spending is only going to create an even larger set of problems in the very near future...

If a company needs to survive by getting handouts from the American taxpayer, they are all doomed. If Paulson and Pelosi continue their spending WE are also doomed.

The situation was totally different in the 80's when Chrysler got their loan -- they actually gave the government something called a BUSINESS PLAN -- how we were going to get our money back. Now all we get is the companies going to Nancy with statements like" We are GM and we are a part of the American heritage and can't fail. They think they have some entitlement because of their name! Move over Woolworth's -- company's on the way!

NOTE: It makes me sick how the big three automakers are giving this sob story of how many will be put OUT OF WORK if they fail... MILLIONS.
What they DON'T tell you is many of those people who will be put out of work are from OUTSOURCED SUPPLIERS IN CHINA, MEXICO, ETC.

2008 Nov 11 04:20 PM

[User 265729:]

PS: While you are looking for money, perhaps you may want to look for the $2 TRILLION -- THAT'S RIGHT -- $2 TRILLION that Fed and Treasury don't want you to know where it went.

That gives me so much CONFIDENCE in this SCHEME...

From Bloomberg:

www.bloomberg.com/apps...

2008 Nov 11 04:23 PM

[TimT:]

RE: The GSE Carry Trade...???
I'm not sure the author can come up with a single instance where a Member Bank could borrow from the FHLB at a rate lower than what the Fed pays on excess reserves. Perhaps Freddie and Fannie are loaning funds that I am not aware of but I don't think so?

2008 Nov 12 11:35 AM