Yet another week of institutional changes that render all those nice macroeconomic texts and professors’ lecture notes obsolete.
The interest rate at which banks lend their Federal Reserve deposits to one another overnight is known as the fed funds rate. For the last 20 years, U.S. monetary policy has been primarily implemented by setting a target for this interest rate. Changes in the Fed’s target are widely discussed in the financial press as key economic developments.
There was yet another announcement from the Fed this week that caused my jaw to drop, though you’d think I’d be getting used to such surprises by now. The Fed announced on Tuesday that it will raise the interest rate it pays on both required reserves and excess reserves to the level of the target itself, currently 1.0%.
My first reaction was, How in the world could that work? Why would any bank lend fed funds to another bank at a rate less than 1%, exposing itself to the associated overnight counterparty risk, when it could earn 1% on those same reserves risk free from the Fed just by holding on to them? It would seem paying 1% interest on reserves should set a floor on the fed funds rate, so that any fed funds actually lent between banks would have to offer a higher rate than the official “target.”
But I’ve always been more persuaded by facts than by theories, and the effective fed funds rate reported for Thursday– the first day of the new regime– was 0.23%. So much for that theory. But what’s going on?
The answer begins with the observation that 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.
But that’s not a sufficient answer by itself, because there’s an incentive for any bank that is eligible to receive interest from the Fed on reserve balances to borrow those balances from the GSE at a rate less than 1%, get credited by the Fed with 1% for holding them, and profit from the difference. Why wouldn’t arbitrage by banks happy to get these overnight funds prevent the rate paid to the GSEs from falling below 1%?
Wrightson ICAP (subscription required) proposes that part of the answer is the requirement by the FDIC that banks pay a fee to the FDIC of 75 basis points on fed funds borrowed in exchange for a guarantee from the FDIC that those unsecured loans will be repaid. If you have to pay such a fee to borrow, it’s not worth it to you to pay the GSE any more than 0.25% in an effort to arbitrage between borrowed fed funds and the interest paid by the Fed on excess reserves. Subtract a few more basis points for transactions and broker’s costs, and you get a floor for the fed funds rate somewhere below 25 basis points under the new system.
Under this regime, the effective fed funds rate– a volume-weighted average of the rate associated with fed funds traded on a given day– would come in above the target if it is dominated by actual banks borrowing fed funds, and below target when dominated by GSE lending. In the latter case, the effective fed funds rate would seem to be a particularly meaningless statistic, reflecting nothing more than the institutional peculiarities just detailed.
That means a couple of things for Fed watchers. 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. I continue to have concerns about implementing the latter in the form of expansion of excess reserves, which ballooned by another quarter trillion dollars in the week ended November 5. Instead, I would urge the Fed to be buying outstanding long-term U.S. Treasuries and short-term foreign securities outright in unsterilized purchases, with the goal of achieving an expansion of currency held by the public, depreciation of the currency, and arresting the commodity price declines.
But the last thing we should expect to do us any good would be further cuts in the fed funds target.