Some further thoughts on the bizarre behavior of the interest rate that used to be the core instrument of U.S. monetary policy.
First, a little background. The fed funds rate is the interest rate at which institutions lend their deposits held in accounts with the Federal Reserve to one another overnight. This is a market-determined interest rate which in normal times was quite sensitive to the quantity of these deposits that the Fed creates. For the last 20 years, U.S. monetary policy was primarily implemented by setting a target for the fed funds rate and changing the quantity of reserves available to the banking system so as to try to get the effective fed funds rate (a volume-weighted average of all the trades during a day) close to the desired target.
But we entered a brave new world on November 6 when the Fed began paying banks 1% interest on those deposits, the same rate as the target itself. This should have ensured that the effective fed funds rate never falls below the target. And yet the effective rate has never been above 35 basis points since the new policy of paying 100 basis points in interest on excess reserves was implemented.
There are two reasons why this tendency for the effective rate to come in well under the target rate is puzzling. The first is the obvious question: Why would anyone make a risky fed funds loan to another bank that only earns 0.35% when they could instead earn 1.0% at no risk by just doing nothing and letting the Fed pay them for holding excess reserves? I suggested the answer to this part of the puzzle when I first began discussing this issue:
the GSEs and some international institutions also have accounts with the Fed. But unlike regular banks, these institutions earn no interest on those reserves, so they would in principle have an incentive to lend out any unused end-of-day balances as long as they earn a positive interest rate.
So far, so good. But there’s a second part of the puzzle. If you’re a bank and there’s a GSE out there willing to lend fed funds at 0.35%, how much do you want to borrow? Let’s look at the math. If you borrow $1 billion, you pay 0.35% interest and earn 1.0% from the Fed for just holding those funds overnight, from which you’d net $6.5 million over the course of a year. If you borrow $10 billion, you’ll earn $65 million. Totally risk-free, $65 million for your bank as pure profits. Here’s the question– How much would you like to borrow?
Me, I’d like to borrow a few gazillion. And lest somebody else get to the GSEs for some of this easy action ahead of me, I’m happy to leave a standing order with my broker. I’ll pay, say, 0.5% to anybody, any time, to borrow any volume of overnight fed funds. So why wouldn’t profit-seeking behavior by banks eliminate this ridiculously easy profit opportunity?
When I first looked at this puzzle, I thought it could be explained by the guarantee fee that the FDIC assesses on any bank when it borrows. But Rebecca Wilder pointed out the flaw in this reasoning was that although the guarantee is now in effect, the banks don’t have to pay the guarantee fee until next month.
I then posed this as an open question to others. I thank the many readers who responded and particularly James Hymas of the excellent PrefBlog for summarizing the various suggestions from around the blogosphere. James ends up favoring two possible explanations. The first is that, as a bank borrows these fed funds, its total assets increase, but its equity capital remains unchanged, so that its leverage ratio deteriorates. Banks may therefore be reluctant to conduct this arbitrage, acting as if there is an internal charge of around 70 basis points assessed on every dollar of fed funds borrowed. This internal charge could play the same role in their calculations as the explicit FDIC guarantee fee discussed in my original article.
I have to say that if this is the explanation, it is profoundly disturbing to me. If banks indeed are finding themselves hamstrung to the point that they are unwilling to pick up millions of dollars that are just lying around on the sidewalk, absolutely risk-free, then how can they possibly be expected to function in their traditional role of funneling capital to legitimate investments that all necessarily entail some risk? If this is indeed what is going on, we should be looking at the spread between the effective fed funds rate and the interest rate paid on excess reserves as another indicator of a profoundly sick financial system, indicative of even deeper problems than other widely watched numbers such as the TED spread.
The second component of James’ explanation is that the GSEs themselves may be willing to lend only limited amounts to a small group of particular banks. That would give these potential borrowers some monopoly power and perhaps limited incentive to try to bid a higher rate to borrow more. There is some risk to the GSE from lending the funds to any arbitrary institution, namely the risk that the borrower will become insolvent overnight and for some reason the FDIC guarantees on those lent fed funds won’t be honored. Surely these are small risks, but they are risks nonetheless, so I can’t view the unwillingness of the GSEs to seek better terms from its borrowers with the same incredulity as I have if there’s some bank out there unwilling to borrow from the GSEs at 0.5%.
The bottom line I come away with, besides some added concerns about how deep the problems may be with the interbank lending market, is the same conclusion I offered when I originally discussed this anomaly:
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.