Sunday, November 9, 2008

The fed funds market is not new and improved until November 13

Prof. James Hamilton at Econbrowser suggests that the differential between the federal funds target and the effective federal funds rate – currently 0.77% - can be explained by two phenomenon: (1) the participation of government sponsored entities (GSEs) and other international banks that do not receive reserve interest from the Fed but participate in the federal funds market (overnight inter-bank lending) and (2) there is a new FDIC insurance fee equal to 0.75% attached to each fund traded.

I do not agree with this assessment because the FDIC’s temporary debt guarantee program does not charge the 75 bps fee until November 13. And furthermore, the new formula used for reserve interest did not go into effect until November 6, and so Prof. Hamilton’s example would be valid only for one trading day (the two-week maintenance period ended on November 5, and the reserve interest paid during that period was 0.65%).

As of November 6, the reason that the effective rate is trading below its target is simply the case of a huge supply of reserve funds (an added $1.2 trillion over the year) coupled with some participants in the federal funds market (the GSEs, for example) that do not earn interest on reserves held with the Fed.

A glance at the effective rate, the spread, and new bank creditThe chart illustrates the spread (difference) between the federal funds target set by the FOMC and the effective federal funds rate – the rate at which overnight inter-bank lending actually occurs – on a daily basis and on average over the two-week maintenance period. The Fed tallies up bank reserve holdings as a daily average every two weeks, rather than each day. You can see this on the Fed’s H.3 Table of aggregate reserve balances.

Until 9/10/08, the effective federal funds rate traded very close to target with an average spread of 3 bps over the two-week maintenance period (bps is the interest rate in basis points, or 100 *interest rate). As soon as the Fed stepped up its liquidity measures (the vertical black lines on the chart), the weighted spread between the federal funds target and the effective federal funds rate grew quickly: the average spread over the maintenance period ending on 9/24 was 11 bps; on 10/8, it was 55bps; on 10/22, it was 68 bps, and on 11/5, it was 69 bps.

The table lists the Fed’s issued bank credit, new bank credit over the year, and the interest spread between the federal funds target and the interest paid on excess reserves. The bold text refers to the date that marks the end of each reserve maintenance period, or the inflection points on the red line in the above chart (data in yellow boxes).

For each maintenance period when interest is being paid on reserves, the spread between the target fed rate and the effective federal funds rate is different than the associated interest spread; there are market forces that create a wedge between the theoretical lower bound on the effective funds rate and its actual lower bound (see this post for a discussion of the theoretical lower bound); two things account for this.

First, the huge influx of bank credit increased the reserve base for all banks, and in spite of a surge in excess reserves, the incentive to loan overnight funds grew. This is seen in the second column of the Table; as soon as the credit affecting reserves rose from $31 billion over the year on 9/10 to $275 billion over the year on 9/24, the effective funds rate traded well below its target by an average of 81 bps from 9/10 to 9/24 (the average of the daily spread, or the blue line, in the chart). And no interest was being paid during this period.

Second, as soon as interest was being paid on excess reserves, the GSEs and other banks that hold reserves with the Fed but do not qualify for the new reserve interest payments were forced to offer very low rates in order to sell the overnight funds. The announcement that the Fed would pay interest on reserves (IOR) went into effect on October 9. During that maintenance period, the average spread between the federal funds target and the effective federal funds rate grew to 68 bps. The GSEs forced the market rate downward with the excess supply of reserve balances.

Specifics on the FDIC program and the IOR policy

I do not agree with Prof. Hamilton (Econbrowser) – that the FDIC debt guarantee fee explains the differential – for two reasions.

First, the FDIC’s temporary liquidity Guarantee program (TLGP) has started, but the fees for the program (75 bps in the Econbrowser example) will not be attached to the cost of the overnight loan (the federal fund) until November 13. From the FDIC’s FAQ page on TLGP:

"How will fees be assessed for the unsecured debt guarantee part of the Temporary Liquidity Guarantee Program?

Beginning on November 13, 2008, any eligible entity that does not choose to opt out of the debt guarantee component of the program will be charged fees that will be determined by multiplying the amount of eligible guaranteed debt times the term of the debt (in years) times 75 basis points."

And from another document written on October 16:

"There are some conditions and caps on that that Art will get into in more detail, but the program is effective now, and we want you to use it. It's 30 days for everybody, and then you have the chance of opting out. If you do not opt out, then we'll start assessing a premium, which on the unsecured senior debt piece of this is 75 basis points."

RW: So you see, the banks do not pay the 75 bps on the federal funds (unsecured senior debt) through TLGP until November 13. However, it will be interesting to see what happens when the FDIC’s TLGP does go into effect on November 13; effective rate is bound to be very, very close to zero.

And second, Prof. Hamilton maps out this example:

"But that's not a sufficient answer by itself, because there's an incentive for any bank that is eligible to receive interest from the Fed on reserve balances to borrow those balances from the GSE at a rate less than 1%, get credited by the Fed with 1% for holding them, and profit from the difference. Why wouldn't arbitrage by banks happy to get these overnight funds prevent the rate paid to the GSEs from falling below 1%?

Wrightson ICAP (subscription required) proposes that part of the answer is the requirement by the FDIC that banks pay a fee to the FDIC of 75 basis points on fed funds borrowed in exchange for a guarantee from the FDIC that those unsecured loans will be repaid. If you have to pay such a fee to borrow,
it's not worth it to you to pay the GSE any more than 0.25% in an effort to arbitrage between borrowed fed funds and the interest paid by the Fed on excess reserves. Subtract a few more basis points for transactions and broker's costs, and you get a floor for the fed funds rate somewhere below 25 basis points under the new system."

RW: The new interest rate on excess reserves did not go into account until November 6 (the day after the latest reserve maintenance period), and the effective federal funds rate traded at 0.23% on November 5. Actually, the effective federal funds rate had traded between 0.22% and 0.23% since 10/31 08 (oval in chart above).

It looks to me like the Fed’s IOR rate is essentially meaningless as long as GSEs are trading federal funds. I bet that there will be an announcement going forward that will modify the IOR rules temporarily to include all firms that hold reserves with the Fed, not just the depository institutions covered under the Fed’s umbrella.

Rebecca Wilder


  1. Good thinking. The Fed is making this up as they go along anyway.

  2. Your kidding? Why would banks pay so much money for virtually risk free Fed Funds??? Who's the biggest borrower & how much would this cost them? How frequently do they borrow?

    Why watch interest rates? These operations are losing their effectiveness as the volume of inter-bank demand deposits at the District Reserve Banks grows.

  3. re-distributed surplus vault cash has dropped to the same level as it was back on April 26, 2006

  4. "There is general agreement that, for almost all banks throughout the world, statutory reserve requirements are not binding. Banks need central bank deposits for clearing checks and making other interbank payments, which gives the central bank leverage over money and bond markets"

    "As I tell many audiences, the FOMC targets the federal funds rate, nominally the rate banks charge each other on overnight loans of deposits at the Fed. In fact, what the NY Open market Desk sets each day is the one-day repo rate on Treasuries, that is, the one-day cost-of-carry on government bonds. This is the true policy instrument -- and it affects huge amounts of money (essentially, the one-day return on all government securities), while fed funds transactions daily, in comparison, are a trivial amount. Folks who actually deal in money markets know this; others usually do not"

    Richard G Anderson
    Federal Reserve Bank of St Louis

  5. I would be surprised if the majority of depository institutions actually pay for this insurance. Relatively speaking - it's expensive.

    Payment of interest on inter-bank demand deposits (IBDDs) held in the District Reserve Banks, owned by the member banks (or excess & required reserves) is similar to its predecessor (the federal funds "bracket racket"). Sell securities when rates hit the bottom bracket (floor). Buy securities at the top bracket (ceiling).

    This practice began in c. 1965. This practice ended July 1989.

    Pegs didn’t disappear with Paul Volcker. Volcker targeted non-borrowed reserves, not total reserves, but the fed funds brackets were widened, not eliminated. Consider that one dollar of borrowed reserves provides the same legal-economic base for the expansion of the money supply as one dollar of non-borrowed reserves. During Volcker’s administration, at times 10% of all reserves were borrowed. Consider what would happen if Bernanke ignored borrowed reserves today.

    Then from July 1989, until Oct 9 2008, the fed funds rate was tied to a series of temporary targets (pegs).

    Now monetary policy has shifted to the payment of interest via pegs on "excess balances". This is an indirect method by which the "trading desk" can raise reserve requirements. The larger the volume of excess reserves, where risk-free interest payments are applied, e.g., excess clearing balances, & pass-through correspondent balances, & re-distributed surplus vault cash (lowest figure since Apr 26, 2006), the lower the banking system's expansion coefficient.

    Also, the payment of interest on these unused balances will drive the FFR lower (other things being equal), as one rate is risk-free & the other inter-bank rate's risk is unknown. Presumably, a reduction in the volume of inter-bank lending may be displaced by targeting legal reserves - because of a disproportionately larger volume of excess-balances (and potentially redistributed, excess vault cash, etc). This is still an experiment.

    To be effective, the (free) legal reserves of commercial banks must be confined to a bank asset that can be constantly monitored and controlled by the monetary authorities. Only Federal Reserve Bank inter-bank demand deposits (IBDD) meet this condition. The volume of (IBDDs) is almost exclusively related to the volume of Reserve Bank credit. I.e., Reserve Banks acquire Treasury Bills, etc., by creating IBDDs – the (free) legal reserves of money creating institutions. Hopefully, this change will tighten the linkage between reserves and bank credit (the money multiplier).

    There are 5 interest rates (ceilings tied to the Primary Credit Rate), that the Fed can directly control in the short-run; the Discount Rate charged to bank borrowers, as well as, the PDCF, ABCP, ABCP MMF, MMIFF & the bank’s “tax rebate”. The effect of Fed operations on all other interest rates is still INDIRECT, and varies WIDELY over time, and in MAGNITUDE. E.g., TSLF, CPFF, OMO, TAF, & SOMA.

    Interest rate “pegs” are based on the absurd belief that there is, at any given time, a federal funds rate which is consonant with the proper level and rate of growth of bank credit and the money supply.
    One last note: New Zealand pioneered payment of interest on reserves, and its rates soared to + 8%. And all countries Governor Laurence H. Meyer cited as illustrations - report m3

  6. Let me see a show of pseudonyms that thinks the "trading desk" will tolerate "failures" in the fed funds market!!!!!!

  7. You should be watching the "Stop-Out" rate.
    Temporary Open Market Operations

  8. Hi Flow5,

    Thank you for reading and commenting. And thank you for your insights on monetary policy.

    You said, “Why watch interest rates? These operations are losing their effectiveness as the volume of inter-bank demand deposits at the District Reserve Banks grows.”

    The Fed has lost control over the effective rate, which is why the Fed introduced the IOR policy in the first place, and further modified the IOR rate two times since its introduction on October 6 (just another rate getting lost in the mix). And yes, reserve deposits have skyrocketed: aggregate reserves with the Fed (H.4.1 table) on November 5: $493 billion; aggregate reserves held with the Fed on November 7, 2007, just $9 billion. The Fed is trying to heal the credit markets, but biggest signal of health in the credit system is not how high is the reserve base (lowering the target) us, but perhaps high is the 10-yr (or even 3month, which is still hovering around 25 bps) Treasury yield – I totally agree with Prof. Hamilton on this point. The short-term Treasury market is negative in real terms, which does not bode well for the health of the U.S. economy and monetary policy going forward.

    You said (after a nice quote from Richard Anderson), “I would be surprised if the majority of depository institutions actually pay for this insurance. Relatively speaking - it's expensive.”

    I totally agree. It will be interesting to see how many banks choose to opt out on December 5, since the TLGP is by definition temporary. We will find out, though, since the FDIC will list the banks that opt out around December 19.

    As you point out, monetary policy is not well defined at this juncture. It seems that the most effective Fed policy right now is the commercial paper funding facility, which supports credit markets directly (this facility grew by $185 billion just last week).

    Thanks again, Rebecca

  9. Why not add the volume from all of the liqudity facilities that borrow at the "penalty" rate. Then borrowing levels should be inversely proportional to "tight" money & "easy" money.

  10. "When the Federal Reserve System was established in 1913, lending reserve funds through the discount window was intended as the principal instrument of central banking operations"

    Ever since George Mitchell, advances by the 12 reserve banks were not closely monitored to prevent the use of these funds for profit, that is, to finance an expansion of thee applicant bank’s earning assets.

    So beginning on Jan 9 2003 the "Reserve Banks would only extend primary credit on a short-term basis (typically overnight) to depository institutions with strong financial positions and ample capital, at a rate ABOVE the target federal funds rate" (penalty rate).

  11. "short-term Treasury market is negative in real terms, which does not bode well" Yes, this is Bill Gross's bubble.

  12. nice post, but really, if you were trying to be anonymous, why the picture? :)


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