As part of the Emergency Economic Stabilization Act of 2008 , the Fed is now able to pay interest on total reserves held by banking institutions – required reserves plus excess reserves. I imagine that the rationale is to reduce the banks' inefficient use of resources to minimize the profit losses of holding reserves (since they earned no income on reserves). Now, banks – just like everybody else – earns income on reserves (deposits), changing the opportunity cost of holding reserves. The outcome is hopefully a more efficient level of bank reserves held with the Fed. The market rate, however, is set by the Fed – kind of funny because then it ceases to be a market rate.
The Fed initially set the interest rate paid on required reserves equal to the average federal funds target over 14 days (the reserve period) less 10 bps, currently about 0.9%. And the interest paid on excess reserves –reserves held by bank above what is required by the Fed – was the lowest federal funds target minus 75 bps, currently 0.25%. On October 22, the Fed changed the excess reserve interest rate to the lowest target minus 35 bps, currently 0.65%.
Going forward, this new policy (paying interest on excess reserves) creates a wedge between the federal funds target and the effective federal funds rate equal to 0.35%. Think about it, if I am Bank of America and I am looking to loan my excess reserves at a market interest rate equal to 0.60%, why would I do that if the Fed is paying 0.65% for the same funds? I take my funds out of the market – and so do other banks – which drives down the supply of loanable funds, and the interest rate rises. If the market rate exceeds 0.65%, let’s say 0.70%, then banks increase loan activity rather than earning the Fed’s 0.65% interest payment, and the interest rate falls. Arbitrage pushes the interest rate to 0.65%, which is 0.35% below the target (1%). Therefore, the federal funds target will never meet the effective funds rate again, and the difference between the two will be 0.35% (provided the Fed doesn't change the formula again).
Therefore, there is no correlation between the $900 billion in new liquidity that the Fed has injected since last year (most of it in September and October) and the effective funds rate trading below its target (see chart).
Here’s a little math: Since October 1, the average federal funds target rate is 1.60%, the average effective federal funds rate is 1.08%, and the average payment on reserves is 0.55%. Therefore, the difference between the average federal funds target and effective federal funds rate is:
1.60% - 1.08% = 0.52%, which is the average payment on reserves, 0.55%.
I apologize for my previous posts, where I suggested here that the Fed is unable to properly target the effective rate and here where I suggested that the Fed would cut its target because the effective funds rate is already below the target rate. But I was partially correct since the deviations started before the new policy (see September data in the chart). The mass amounts of liquidity that the Fed injected starting in the middle of September did push the effective rate well below its target (2% at the time). The Fed could not raise the effective rate closer to its target without extracting precious liquidity, which would have done more harm than good in the middle of a banking crisis. Further, it doesn’t seem like many other people/bloggers have a firm grip on this, so I will just leave it at that.