Fed funds question (seriously wonkish, and possibly dumb too): The target Fed funds rate is now 2.25%. Everyone expects it to be reduced further; Citi economists predict that it will be down to 1% by mid-year. But I have a possibly naive question: can the Fed really cut the Fed funds rate that far?... The Fed actually conducts monetary policy through open-market operations in Treasuries: the FOMC tells the open-market desk to buy or sell Treasuries from banks until the Fed funds rate is close to the target. Normally this puts Treasury interest rates close to the Fed funds rate, since one short-term loan to a very safe customer is a lot like another.
But right now Treasury interest rates are much, much lower than the Fed funds rate -- around half a percent on both 1-month and 3-month bills. Weirdness like negative rates on repos aside (I'm still trying to wrap my mind around that one), basically the Fed can only drive Treasury rates down by about another half-point -- which would still seem to leave Fed funds well above 1%.
How is it possible for the Fed funds rate to be higher than the Treasury rates? Well, one interpretation is that banks don't trust each other.... Fed fund loans, after all, are unsecured. In other words, the Fed funds rate may be more like LIBOR than the Treasury rate -- and it may be being held up by a premium similar to the TED spread.
Am I being really stupid here? Or is it possible that the fear factor will soon make it impossible for the Fed even to achieve its target on the interest rate it supposedly controls?
No, this is not stupid. As Clouse and Elmendorf (1997) write (.pdf): "Because funds-market trading is typically not collateralized, the funds rate can also differ across borrowers according to their perceived riskiness." This has in fact been happening since last August--what the (average) fed funds rate is on any given day depends on who is doing the borrowing.
As Jim Hamilton wrote last August:
Econbrowser: Their objective is defined in terms of a volume-weighted average of all the transactions during the day (referred to as the "effective" fed funds rate), with the target for the effective rate currently declared to be 5.25%. The Fed usually makes at most one such intervention early in the day, and is then content to allow the actual fed funds rate at which banks choose to borrow or lend to each other fluctuate above or below the target. Often at the end of the day, and especially on the last day of the two-week period in which banks have to complete the satisfaction of their required average holdings of reserves, one will see the fed funds rate spike up, if some bank finds itself unexpectedly needing funds at a time when everybody else is finished trading for the day, or fall to practically zero, if some bank unexpectedly finds itself with excess funds that nobody else is interested in borrowing. As William Polley noted, this last week these intraday fluctuations have been particularly dramatic, with one trade last Wednesday (a settlement day) as high as 6% and another on the same day for only 0.25%.
Why does the Fed allow so much intra-day variability in the interest rate it is intending to target? One reason is that the Fed does not want to be in a position of subsidizing individual banks that choose to make unusually risky investments. If a bank knew that, no matter what it did, it could always obtain an unlimited source of funds at a 5.25% rate, the bank would have an incentive to borrow a huge quantity of such funds and use them to make higher yielding, but potentially quite risky, investments.... The Fed intentionally allows different banks, in different circumstances or at different times of the day, to pay a higher or lower rate for fed funds than do other banks, as one way of making sure that banks face immediate consequences of any extra risk-taking....
Of course, there is an inherent tension between the goals of serving as lender of last resort and making sure that banks are disciplined for risky behavior, and this tension is at the heart of the current policy dilemma facing the Fed. To help to achieve these twin objectives, the Fed has a separate tool, the discount window, through which it offers to lend directly to banks, temporarily giving them newly created reserves while holding high-quality assets as collateral for such loans. Again there have to be some institutional checks to prevent excessive risk-taking for banks using this facility. Historically, the Fed achieved this by placing additional limitations and regulatory oversight on banks that borrowed too much or too frequently at the discount window. Partly as a result of these, the discount window acquired a certain stigma...
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