Friday, January 29, 2010

Alert (Sort Of ): Fed May Stop Targeting Fed Funds

File this baby under "Why you read EPJ."

Bob Murphy sends me a link to a Scott Sumner piece on news that the Federal Reserve may stop targeting the Federal Funds rate.

Sumner quotes a January 26 Bloomberg story:
Federal Reserve policy makers are considering adopting a new benchmark interest rate to replace the one they’ve used for the last two decades.

The central bank has been unable to control the federal funds rate since the September 2008 bankruptcy of Lehman Brothers Holdings Inc., when it began flooding financial markets with $1 trillion to prevent the economy from collapsing. Officials, who start a two-day meeting today, have said they may replace or supplement the fed funds rate with interest paid on excess bank reserves.

“One option you might want to consider is that our policy rate is the interest rate on excess reserves and we let the fed funds rate trade with some spread to that,” Richmond Fed President Jeffrey Lackertold reporters on Jan. 8 in Linthicum, Maryland
Sumner calls this a "momentous change."

So is this a "momentous change"? Is Richmond Fed President Lacker on to something here? Er, yup. But it is only recognizing reality. I acknowledged the importance of the interest rate on excess reserves versus the Fed funds rate in 2008. Back then the Fed was doing something a bit different with the rate on excess reserves versus the Fed funds rate, but it was clear that the rate on excess reserves would become the key rate. On October 7, 2008, I wrote:

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...

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 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.
Sumner calls the Bloomberg story a "trial balloon." I think it is simply recognizing the major significance that the excess reserve rate already has on monetary policy. The rate on excess reserves now controls monetary policy to a greater extent than the Fed Funds rate. But all this is dependent on the interrelationship between the Fed Funds rate, the excess rate and the real rate (The real rate being the rate that would exist without Fed interference in the interest rate market.)

The Fed could put the Fed funds rate back into play by setting the rate on excess reserves below the real rate. That they are not clearly indicates that they have already moved to the excess reserve rate as the dominant monetary policy weapon.

Making a formal notice of the Fed targeting reserve interest rates would serve only to confirm the reality of the situation dating back to October, 2008.

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