The Federal Reserve System (the Fed) was chartered via the Federal Reserve Act of 1913. The purpose of this article is not to discuss the history of the U.S. banking system or argue the pros and cons of the Fed, so I'll spare you those details and opinions today. The Fed is technically a private bank and serves as a bank for banks and for the U.S. government. However, they do play a significant quasi-government role by fulfilling their stated mission of providing a "safer, more flexible, and more stable monetary and financial system."
To fulfill their role, they participate in the financial markets by regulating banks, managing the money supply, and influencing interest rates. Much of this participation is conducted by so-called "open market operations" where they trade directly with twenty-two "primary dealers" via the New York Fed (there are twelve Fed banks, but the NY branch has the special authority to conduct open market operations). These operations are intended to drive the interbank lending market toward a targeted interest rate known as the Fed funds rate.
Here's how it works. Let's recall previous examples where we have discussed reserve requirements. It is actually the Fed who set reserve requirements in the U.S., and banks keep most of their reserves on deposit with the Fed (remember, they are a bank for banks). So, let's say we have Bank A, Bank B, Bank C and Bank D, and let's say that they each have $100M of deposits from their customers so they need to keep $10M on reserve with the Fed. In the previous article on LIBOR, we learned how day-to-day bank operations may leave a bank in a position with either excess or insufficient reserves. If Bank A and Bank B are left with $8M and $9M respectively, while Bank C and Bank D have $11M and $12M respectively, the market will have the potential to regain equilibrium with inter-bank loans. Remember, loans are not free; Banks C and D will charge interest.
The Fed funds rate is actually just a target interest rate set by policy makers of the Fed (the Federal Open Market Committee). If the Fed funds rate is, say 3%, then the Fed will monitor interbank loan activity conducted between member banks (not just the primary dealers) and take action if the lending rates deviate from 3%. So, in our example, if the loans above between the four banks clear with overnight lending rates of 3.1%, then the Fed will take action to drive interest rates down 10 basis points. How do they do this? They perform open market operations.
If the interbank lending interest rates for loans conducted by banks with the Fed are too high (called the effective Fed funds rate), that means that there is relatively too much demand for money relative to supply. The Fed will counter this by increasing the money supply. In open market operations with their primary dealers, the Fed will purchase U.S. Treasuries (generally) from primary dealers and credit their accounts with new cash reserves. This action will increase the supply of money as it will increase the reserves of the primary dealer in the transaction which either decreases their demand for a loan or increases their ability to make a loan on their excess reserves. This drives down interest rates. It should be noted that this leaves the Fed with a significant balance of U.S. Treasuries - more than anyone else in the world.
Ok. So, let's take a look at the history of the Fed funds rate. The graph below shows both the target and effective rates since 1983.
Data from St. Louis Fed via FRED(R).As you can see the two rates follow each other very closely. There have only been a few rare circumstances where the two rates have deviated significantly. Most graphs that I have seen with the Fed funds rate show the target rate. To me, it makes more sense to show the effective rate since this is the actual rate which clears in the marketplace of interbank lending. The target rate is important to understand from a public policy direction and certainly drives the market.
This next graph shows the 30-day moving average of the spread between the effective and target funds rates along with (in red) the times in which the Fed has announced a change in the target rate. (The position of the red dot indicates the direction and magnitude of the change.)
There are a few important things to take away from this graph. First, note the series of "negative red dots" between the beginning of 2001 and mid-2003. The Fed drove rates down from 6.5% to 1% over a thirty month period. This was followed by a steady increase in rates from mid-2004 until mid-2006 where rates went from 1% to 5.25%. We are now in another period of rate reduction, but this time there is something different. Since September of 2008, the beginning of the most severe period of the credit crisis, the effective Fed funds rate has deviated from the Fed funds target rate at an unprecedented level (at least since 1983 where my data set begins).
I would argue that the Fed's policy shift to reduce the target rate to a range of 0-0.25% was fairly easy to predict. The exact action was not necessarily easy (they've never used a range before), but the direction was obvious. The effective rate was far below the target every day between October 10 (just three days after a rate cut from 2% to 1.5%) and December 15. Since the rate cut on December 16, the effective rate has remained within its target and average 0.13%.
In our next article in this series, we'll look at rates on U.S. Treasuries.
There are a few important things to take away from this graph. First, note the series of "negative red dots" between the beginning of 2001 and mid-2003. The Fed drove rates down from 6.5% to 1% over a thirty month period. This was followed by a steady increase in rates from mid-2004 until mid-2006 where rates went from 1% to 5.25%. We are now in another period of rate reduction, but this time there is something different. Since September of 2008, the beginning of the most severe period of the credit crisis, the effective Fed funds rate has deviated from the Fed funds target rate at an unprecedented level (at least since 1983 where my data set begins).
I would argue that the Fed's policy shift to reduce the target rate to a range of 0-0.25% was fairly easy to predict. The exact action was not necessarily easy (they've never used a range before), but the direction was obvious. The effective rate was far below the target every day between October 10 (just three days after a rate cut from 2% to 1.5%) and December 15. Since the rate cut on December 16, the effective rate has remained within its target and average 0.13%.
In our next article in this series, we'll look at rates on U.S. Treasuries.
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