Tuesday, October 28, 2008
Tomorrow the Federal Open Market Committee (FOMC) – the group in charge of the Fed's open market operations – meets to set the new federal funds rate target. The federal funds rate target is the rate that the FOMC controls by adding or extracting money from bank reserves in order to push the interest rate that banks pay on overnight loans between each other (the effective federal funds rate) either up or down.
Outcomes of the FOMC meeting are:
(2) Raise the target rate – epsilon possibility (really, really small)
(3) Lower the target rate – likely outcome.
The market believes a rate cut is all-but a certain outcome – with 50bps to 1.0% being the expected target. From Reuters :”U.S. short-term interest rate futures were higher on Tuesday, underlining expectations for an aggressive rate cut from the Federal Reserve this week, after a severe drop in consumer confidence.”This is a good idea, but not because the Fed will actually increase the monetary base - because the effective rate is already at or below 1%.
The effective rate has been trading well below the Fed’s target – currently at 1.5% - since 10/10/2008. The Fed has increased interbank liquidity in order to jumpstart lending (the size of the Fed’s balance sheet is almost $1 trillion larger than it was just one year ago), and without counteracting the positive effects of the liquidity measures, the Fed is allowing the effective rate to run below its target. Thus, a 50bps cut is just for show. However, the effective funds rate will always trade at least 35 bps lower than the target rate for as long as the Fed pays interest on excess reserves.
However, I don’t believe that if the Fed targets 1% that it will let the effective rate fall to zero; that is not credible. All a 50bps cut would do is to give the Fed a little credibility back, and push the differential between the target federal funds rate effective federal funds rate back to 35 bps (it is currently at 0.58%).