An EPJ Reader Writes the Fed

A long-time EPJ reader wrote a top Fed economist and asked:

The traditional Money & Banking texts like Mishkin, etc. explain paying interest on reserves as the "Corridor Approach" where the Fed Funds rate can never really go below the reserve rate and above the discount rate. If this is so, how can the effective FF rate be below both the "target" FF rate AND the rate paid on reserves? Bloomberg has the effective FF rate at .14 while the target is .25. The reserve rate is .25 also. This deviation was even more pronounced a year ago when the FF rate was .06 while the reserve and target FF rates were .25. How can this be? Thank you for your time and Happy Holiday's.

The senior Fed economist replied:

Hi. You are correct that seeing the market interest rate below the rate paid by the Fed on excess reserves is a puzzle, at least from the standpoint of basic economic theory. The answer to this puzzle lies in a couple of institutional details that are missing in the standard theory.

First, the federal funds rate is not a purely inter-bank interest rate, because some of the participants in this market are not banks. In particular, Fannie Mae, Freddie Mac, and the various Federal Home Loan Banks are large lenders in the federal funds market. These institutions hold accounts at the Fed, just like banks do, but they are not eligible to earn interest on the reserves they hold in those accounts. (Congress has authorized the Fed to pay interest to "depository institutions", which does not include these housing-related entities.). As a result, these entities have an incentive to lend at any positive interest rate they can get.

This first fact explains part of the story: why some institutions are willing to lend at rates below 0.25%. But there is another element to the puzzle: if these institutions are lending at, say, 0.14%, there is an arbitrage opportunity. Any bank could borrow at 0.14, hold the money at the Fed and earn 0.25, and earn a pure profit. Competition between banks to borrow should, in principle, drive up the market interest rate until the arbitrage opportunity disappears. Clearly this has not happened.

Another important institutional fact is that fed funds loans are uncollaterlized. There is usually not much risk in lending money overnight, but we have been through some unusual times. Lenders in this market have become extra careful about who they will lend to. Anecdotal evidence suggests that all of the housing-related entities are willing to lend to the same few banks, which limits the possibility for competition to raise market rates. There is also another wrinkle: borrowing in the fed funds market and leaving the money at the Fed increases a bank's leverage. There is no risk in these actions, but a bank might be reluctant to take advantage of the arbitrage opportunity for fear that investors will misinterpret the reason behind the increase in leverage. These reasons have combined to leave the market interest rate around 10 basis points below the rate paid by the Fed.

I hope you find this explanation useful. I should emphasize that all of the comments above are my own views and in no way reflect any official position of the Federal Reserve. For a more official (and quotable) discussion of this issue, I would refer you to the speeches of Chairman Bernanke (all of which are available on the Federal Reserve Board's website). I don't remember the details offhand, but if you look though his speeches and congressional testimony from last summer I am sure you will find mention of exactly this issue.