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)