Wednesday, November 5, 2008

The Fed Sets A New Boundary for the Fed Funds Rate

The Federal Reserve has had difficulty keeping the effective fed funds rate near the target rate of 1%. An effective fed funds rate that is below the target rate results in a de facto rate cut for banks. Since interbank lending is conducted at the effective rate, a low effective rate means that banks can borrow at rate lower than the Federal Reserve would like. In an effort to fight this the Federal Reserve began paying interest on required and excess reserves held at the Fed. This sets a theoretical lower bound to the effective rate as banks have no incentive to lend at an effective rate that is lower than the rate they can receive on reserves. Surprisingly, this action has still not resulted in an effective rate that is near the target rate. As a further combative measure the Federal Reserve announced today that they would increase the rate they pay on reserves. The Fed's announcement:

The Federal Reserve Board on Wednesday announced that it will alter the formulas used to determine the interest rates paid to depository institutions on required reserve balances and excess reserve balances.

Previously, the rate on required reserve balances had been set at the average target federal funds rate established by the Federal Open Market Committee (FOMC) over a reserves maintenance period minus 10 basis points. The rate on excess balances had been set as the lowest federal funds rate target in effect during a reserve maintenance period minus 35 basis points. Under the new formulas, the rate on required reserve balances will be set equal to the average target federal funds rate over the reserve maintenance period. The rate on excess balances will be set equal to the lowest FOMC target rate in effect during the reserve maintenance period. These changes will become effective for the maintenance periods beginning Thursday, November 6.

The Board judged that these changes would help foster trading in the funds market at rates closer to the FOMC's target federal funds rate.

The following chart illustrates the theoretical upper and lower bounds of the fed funds rate since October when the Fed began paying interest on reserves.

The lower bound is calculated using the Fed's formula while the upper bound is the discount rate. The discount rate is used as the upper bound since theoretically banks should not want to borrow at a rate that is higher than the discount rate. However, there is a stigma attached to using the discount window and therefore the upper bound is more likely to be breached.

It is clear that since October banks have been borrowing at rate well below the target rate, in fact the effective rate was as low as 0.22% on October 31. With this announcement the Fed is trying to implement its monetary policy, the fear is that the excess liquidity will lead to inflation. The fed funds market will be a key place to look for signs of a more normal financial system.

Disclosure: I have no position in the Fed Funds market; I am long RKH and BBT.

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