Sunday, November 9, 2008

The Fed Funds Rate and Why You Read EPJ

One month ago, we posted a note that headlined: Fed Funds Rate Cuts Have Become Irrelevant

In that post we wrote:
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...

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 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.

I have seen ZERO reporting on this extremely important fact, until today.

James Hamilton at Econbrowser covers much of the same territory and also expands on it, by examining (with apparently the help of Wrightson ICAP ) the role of an interesting arbitrage of GSE balances at the Fed that other Fed depository institutions can conduct. His ultimate conclusion:

...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.
Congratulations, to James for figuring out what we did a month ago. It's still a feather in his cap, (You have to be really good to stick with us in real time). Most Fed watchers still don't get what is going on, with the Fed Funds rate.

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