Wednesday, January 26, 2011

Note to Economists: The Fed Funds Rate is NOT 'Essentially at Zero'

James Hamilton writes, though he is not the first:
But by the end of 2008, the Fed had driven the fed funds rate essentially to zero..
The effective Fed Funds rate is currently 0.17%. This is not zero. This is not essentially zero.

This is especially significant when the Treasury bill rate is below the effective Fed funds rate. The 4 weeks T-Bill rate is 0.10%. This means that not only is the Fed Funds rate not zero, but, from a Fed Funds perspective (Not a QE2 perspective) the Fed is not even accomodative. You would need Fed Funds below the T-Bill rate for the Fed to be Fed Funds accomodative. With the Fed Funds rate above the T-Bill rate, the Fed Funds rate is relatively high.

This misconception about the Fed Funds rate seems to be a problem of thinking in relative terms and somehow taking an absolute number that is used in other types of measures, where it would be insignificant, and thinking it is thus insignificant when it comes to the current range of interest rates. This is just poor thinking.

If the T-Bill rate was, say, at 15% and Fed Funds were at 0.17%, you could get away with saying the Fed Funds rate was "essentially zero" because there would be little to no operating significance between a zero rate and a rate of 0.17%, but when the T-bill rate is at 0.10% there is huge operating significance.

4 comments:

  1. "This misconception about the Fed Funds rate seems to be a problem of thinking in relative terms and somehow taking an absolute number that is used in other types of measures, where it would be insignificant, and thinking it is thus insignificant when it comes to the current range of interest rates."

    Spot on, and as I've written, zero is a rather arbitrary level anyway as real interest rates might be higher or lower. Zero does have powerful psychological influence, though. Thanks, Mayans.

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  2. I think the habit of saying "the fed funds rate is at virtually zero" is borne out of a historical comparison, not necessarily a failure to compare to t-bill rates.

    If t-bill rates were currently 88.235% and the fed funds rate were 1% (different absolute numbers than in your example but they have the same relative difference), then it would not make sense to say that the fed funds rate was "virtually zero".

    Suppose t-bill rates held steady at 5% for 10 years, and during that time, the fed funds rate held steady at 4%. If after those 10 years the fed funds rate were to go down to 0.17%, then commentators would most certainly say that the fed funds rate is "virtually zero", and this would probably be the case even if the t-bill rate was either higher or lower than that.

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  3. You compare the Fed Funds rate to the 4-week T-bill rate, because that´s the shortest T-bill rate? The Fed Funds are borrowed just overnight, right?

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