Tuesday, October 7, 2008

Fed Funds Rate Cuts Have Become Irrelevant

A new litmus test has developed to determine how well economists understand the machinations of Federal Reserve operations.

Any analyst now calling for cuts in the Fed Funds rate, or forecasting further cuts in the rate, will fail the test.

Yesterday, the Fed announced that it will begin to pay interest on depository institutions' required and excess reserve balances.

The Financial Services Regulatory Relief Act of 2006 originally authorized the Federal Reserve to begin paying interest on balances held by or on behalf of depository institutions beginning October 1, 2011. The recently enacted Emergency Economic Stabilization Act of 2008 (The Paulson 'Bailout' Plan) accelerated the effective date to October 1, 2008.

The interest rate paid on required reserve balances will be the average targeted federal funds rate established by the Federal Open Market Committee over each reserve maintenance period less 10 basis points.

The rate paid on excess balances will be set initially as the lowest targeted federal funds rate for each reserve maintenance period less 75 basis points.

Paying interest on required and excess reserve balances changes the entire role of the Fed Funds rate with regard to Fed monetary policy, as long as real rates are below the rate paid by the Fed on excess reserves.

The Fed generally adds monetary reserves to the system through its open market operations, i.e., the buying of Treasury securities. This, in the past, had a downward impact on the Fed Funds rate, as the new money the Fed adds shows up as reserves at various banks. Thus, in the past, the more new reserves, the more the Fed Funds rate dropped, since the Fed Funds rate is a rate set by the loaning and borrowing of the reserves. With the Fed targeting the Fed Funds rate, most recently at 2%, the Fed was in effect frozen, by its own target, from adding more reserves to the system if the Fed Funds rate was already at 2% , since any additional purchases of Treasury securities would push the Fed Funds rate below the targeted 2% rate.

Recently, given the crisis environment, the Fed has ignored its own publicly stated Fed Funds rate target and added reserves that pushed the Fed Funds rate below 2%. Last week, the Fed Funds rate traded at 1.56%, 2.03%, 1.15%, 0.67%, 1.10%, respectively from the period September 29 to October 3. This is unusual. The Fed generally stays at its target. So under the old rules, if the Fed wanted to add reserves, it would more than likely cut the target Fed Funds rate below 2%, to keep the target in line with its actual operations. Now, however, with the Fed paying interest on its reserves at a rate near the target Fed Funds rate, the Fed can add any amount of reserves it wants and the Fed Funds rate won't go down, because the Fed is, in effect, simultaneously providing a floor to the Fed Funds rate at the near target rate, or at least the target rate for the excess reserves, since a bank will not withdraw reserves when the Fed will pay it for the reserves.

In summary, in the past, a cut in the Fed Funds rate was required to increase Fed open market operations to add reserves. This is no longer the case, now that the Fed will support the Fed Funds rate by paying interest on required and execess reserves AND it is has always been the actual adding of reserves, rather than the cut in rates that has fueled the economic boom times with the new money flowing into the economy.

Further, because the Fed has put in a spread of 75 basis points between what it will pay on required reserves versus what it will pay on excess reserves, there is increased incentive for banks to put the money to work and get it in the higher paying required reserve column versus the excess reserve column.

The Fed may cut the funds rate in the future for cosmetic reasons to calm the markets, but it is not necessary for the Fed to do so, given that it is now paying interest on reserves at above market rates.

Thus, any analyst calling for a Fed rate cut doesn't understand how the Fed works and the impact the new rule changes will have.

No comments:

Post a Comment