Sunday, November 9, 2008
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.