Monday, March 15, 2010

More Thoughts on the Effective Federal Funds Rate

As I pointed out over the weekend, the effective funds rate has been climbing by roughly one basis point every other day, since the end of February.

This means one of two things is happening:

1. Bankers are beginning to arb the difference between the Fed funds rate and the interest rate on excess reserves (IOER)

2. There is new real demand for Fed funds.

Neither one of these possibilities leads to a particularly pretty picture. In case 1, this means banks are pulling money out of the system. They are borrowing Fed funds and depositing them as excess reserves. This would be an extremely deflationary tight money situation. For the Fed to stop this it would have to lower the IOER, which would move the danger from deflationary to inflationary.

In case 2, the effective Fed Funds rate is climbing because of real new demand. Under this scenario, there is the very real possibility that the funds rate could pierce the high end of the Fed's target of 0.25%. This would most likely force the Fed's hand and cause it to raise the IOER. This could occur a month or so from now, or maybe even sooner--depending at what rate the Fed Funds continues its ascent, if it does.
Such a hike would completely destroy the Fed's plan to delay raising rates until the latter part of the second half. It would completely catch the markets off guard and result in a huge sell off (crash?)
There is no more important number to watch right now than the effective Fed Funds rate.


  1. Robert, I have some questions about the case #1 you described here. I'm not sure if you respond to questions in your comments section, but lately I've been trying to wrap my head around monetary policy and I'm hoping you can help me out.

    My understanding of Federal Funds is that they are excess reserves held by Bank A that are lent to Bank B if B is a little short on it's reserve requirement. Let's say B is not short, but borrows from A to hold excess reserves and earn the higher rate of interest (your case #1). I understand why B would want to do this, but why would A? Wouldn't A be better off just holding the excess reserves and earning the higher interest itself? The logical conclusion of this is that no banks would loan Federal funds at a rate lower than that earned on excess reserves; the IOER would be a floor. Why is this not the case?

    Also, how does Bank A loaning money held as reserves to Bank B to be held as reserves take money out of the system? What am I missing?

  2. @Allen

    Good questions. Here's the answer to part 1

    As for your final question, you have to assume that someone putting money out in the fed funds market is not storing them as excess reserves (becasue they wouldn't then be putting them in the fed funds mkt), so you are drainning funds that were reserves backing up loans and putting them out of the system as excess reseves.

  3. Ah very nice. I had read that earlier answer when you first posted it, but I had forgotten some of the reasons.

    It seems Wenzel that maybe there is a third possibility: Maybe Freddie/Fannie are lending less into the fed funds market? (They aren't eligible to earn interest on excess reserves, which is why they are willing to lend reserves at less than 0.25%.)

  4. @Bob Murphy

    The "third" case is very possible, however, I would just consider it as one of the subsets of "real demand". As in say you might say, as an example, "Hey, military spending is up so banks are lending more to military contractors aren't putting it into teh Fed funds market."

    Whatever the reason, its going to be a big problem for the Fed if it continues.

  5. another possibility: situation 1) could apply because the non-depository institutions in the Fed Funds market have become more liberal about who they'll lend overnight to, thus driving up competition in the system, as per the fed economist's commentary.

  6. Looks like I wasn't the first to ask that question! The link answered my first question exactly. I think it also helps answer my second question. The idea is that a bank that wasn't earning interest on excess reserves wouldn't hold any, they would leverage those funds as reserves backing loans and therefore expand credit. However, in your case #1, they instead loan these funds to banks who earn interest holding them as excess reserves, preventing credit expansion (or as you described in your reply, causing contraction as existing loans get paid off and the reserves backing them get drained for the system).

    Thank you for the reply, it was very helpful.