Since December 2007, the Fed has broadened its basket of policy tools for increasing bank liquidity. These new measures include the Term Auction Facility (TAF), the Term Securities Lending Facility (TSLF), and the Primary Dealer Credit Facility (PDCF). The most recent addition to its policy tool basket is interest the Fed can now pay on bank reserve deposits that are held with the Fed (part of the huge $700 billion TARP). But now that the economy is showing further signs of weakness, the Fed has started beefing up its bread and butter policy tool: slack Open Market Operations (OMO).
The Fed has been adding liquidity across the board for some time now, especially during the month of September. The Fed opened new swap lines with global central banks (last tally was in excess of $600 billion), it sharply increased TAF funding, and it made available lines of credit to firms outside of the depository institutions and primary dealers (e.g., AIG $85 billion loan). But what the Fed hasn’t done is change its fed target since April. Until now, the risk has been centered around financial troubles and not an ostensible deterioration of the macroeconomy.
But a closer look at the data suggests that the Fed has implicitly targeted a lower interbank lending rate (the federal funds rate) because the outlook for the economy has taken a turn for the worse.
The chart illustrates the difference between the effective federal funds rate (the actual overnight U.S. interbank lending rate) and the federal funds target rate since the beginning of the year. The Fed increases or decreases bank liquidity through daily open market operations (most commonly through overnight repo funding) in order to keep the effective federal funds rate close to its target. Since September 2007 (when the Fed first lowered this cycle‘s federal funds target), the average differential has been just -0.03%, or no material difference. However, since the day after Lehman filed for bankruptcy (Sep. 16), the effective federal funds rate has been on average -0.5% lower than its target, and the differential is rising. The effective federal funds rate was 1.3% below its 2% target on Thursday (Oct. 2, the latest point from the Fed database).
In lieu of holding an emergency FOMC meeting – the last unscheduled meeting was July 24 – the Fed is purposefully running the effective rate low, or initiating implicitly further expansionary policy. This gives the Fed a little more flexibility in monitoring the liquidity of the banking system without having to adhere to its announced target.
The Fed is worried about the recent worsening of the macroeconomy. September will prove to be a tough month for the U.S. economy: with nonfarm payrolls falling by -159,000 – which was the first September monthly economic data release and significantly worse-than-expected –consumption, retail sales, and housing data for September will likely take a tumble as well.
In order to accomodate economic growth, the Fed is beefing up its OMO before the October FOMC meeting, when at that time, I expect that it will cut its federal funds target by 75 bps (0.75% to 1.25%). What do you think?