Monday, October 27, 2008

Effective Fed Funds Rate Implies a De Facto Rate Cut

During the market stress of the last two months the Federal Reserve placed saving the system above monetary policy. The result has been a de facto 50 bps rate cut since October 10th.

The Federal Reserve uses its Open Market desk to buy and sell government securities in the fed funds market in an effort to keep the effective fed funds rate at or near the target. The effective fed funds rate is the volume weighted average of trades between banks and represents a proxy for bank to bank borrowing costs.

Typically the Fed is very successful at keeping the effective rate close to the target and by extension implementing their desired monetary policy. However, as the Federal Reserve has pumped liquidity into the market they have not been able to control the effective fed funds rate and as a result the rate has dropped below target for over a month.

The following chart shows the effective fed funds rate superimposed on the target rate for 2008. The massive dislocation and volatility can easily be seen when looked at in relation to "normal" times.

A closer look at the last two months reveals that the effective fed funds rate has been below the target since October 10th, in fact it has remained at 1% or lower during this time. The impact on the market is that banks can borrow at a rate that is 50 bps below what the Fed is targeting.

Prior to October 6, 2008 the Federal Reserve did not have the tools to get the effective rate back to the target, the more liquidity they put in the system the lower the rate fell. The primary reason the effective rate fell below target was because banks had no incentive to hold excess reserves at the Fed. The Fed did not pay interest on bank reserves held at the Fed, therefore as banks received money they had incentive to immediately get rid of it.

Of course this is exactly what the Fed was trying to encourage since lending had all but seized up. The mantra was and still is - get the credit markets un-frozen.

The $700 billion bailout contained a clause that allowed the Federal Reserve to pay interest on reserves held at the Fed. Originally, this was supposed to occur in 2011, but the crisis forced the government to move that date up to October 1, 2008.

This is a critical development because it sets a theoretical or implied floor on the effective fed funds rate. Since the banks will now be getting interest on reserves they have an incentive to hold excess reserves. Prior to the change any excess reserves was simply offered in the fed funds market driving the effective rate down.

On October 6th, the Fed announced that they would pay 75 bps below the target rate on excess reserves. At that time the target rate was 2.00%, thus banks would earn 1.25% on any excess reserves. In theory any time the effective fed funds rate fell below 1.25% the banks would have an incentive to keep their excess reserves and not offer them in the fed funds market. On October 23rd the Fed adjusted the level to 35 bps below the target rate (1.15%). This now represents the theoretical lowest level the effective fed funds rate should trade.

The upper limit on effective fed funds is the discount rate. Since banks can borrow from the discount window, in theory, they would not want to borrow at an effective fed funds rate above the discount rate. This results in an implied or theoretical upper bound to the effective fed funds rate. Of course, theory and reality are two different things. There is a stigma attached to borrowing from the discount window, however it does provide a reasonable estimate of the maximum value at which fed funds should trade.

The result over the last week has been a slow return to more normal levels. Although still below the target rate, the effective fed funds rate has begun to creep back towards the target rate.

While the media focuses on the FOMC meeting and the likely outcome, the reality of lower rates has been with us for some time. A rate cut this week may be good for sentiment, but structurally it may have little impact. As the banks and the Fed get used to this new structure, expect the effective rate and the target rate to converge once again.

Disclosure: I do not have any position in the securities mentioned.

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