THE BASIS POINT

The Fed in a Tight Spot of its own Making

 

 

Apart from laws and regulations there are two important parts which the Federal government plays in the economy. One is fiscal policy – taxes and spending. This is in the hands of Congress and the President. The other is monetary policy. This is controlled by the Federal Reserve and consists, apart from times of extraordinary events, of two things 1) trying to control interest rates and 2) changing money supply.

Before the crisis of 2008 the Fed had excellent control over interest rates. When it said that it wanted to raise or lower the Fed funds rate the market obediently behaved. I believe that this happened because market participants knew that through Open Market Policy the Fed could move the Fed funds rate to their target. Banks which are short necessary reserves borrow overnight from a bank which has excess reserves. The rate banks charge each other for this is called the Fed Funds Rate.

Through QE the Fed has increased the amount of excess reserves banks have. The current amount of excess reserves is $2.568 trillion. With that being so large it is not possible for Fed Open Market participation to have any significant effect on the Fed Funds rate. To understand the scale, excess reserves in September 2015 are more than 1,000 times greater than they were before at any time before August 2008. Through QE the Fed had made it impossible for itself to control the Fed Funds rate.

There is a graph of excess reserves in the following link:

http://loanmine.mortgagexsites.com/xSites/Mortgage/loanmine/Content/UploadedFiles/reserves%20v%20excess%20reserves.bmp

Since Open Market operation could no longer affect Fed Funds the Fed believed that it needed a novel approach to get banks to increase the Fed Funds Rate. The new strategy was to pay banks interest on excess reserves. The notion of having the Fed pay interest on excess reserves was first proposed by Milton Friedman in the 1970’s but the Fed was not allowed to do so until 2008. The Fed started paying interest on excess reserves in January 2009.

The idea was to set a floor on the Fed Funds rate. The thinking was this: if a bank can take it excess reserves and park them at the Fed and get 25 bps interest with zero risk why would it lend them to another bank unsecured and get a low rate? Good question but without a good answer. The Fed Funds target is 0-25 bps but the weighed average Fed funds on any day lately is about 12 bps.

Now an idea which is being floated is that if the Fed wants to increase the Fed Funds rate it may need to increase the interest paid on those excess reserves from the current 0.25%. For argument’s sake let’s say that the Fed increases the interest on excess reserves to a range of 0.25%-0.50%. The thought is this: I am a bank with a lot of excess reserves. You are a guy short reserves. You call me asking what rate I want to lend you $10,000,000 for 24 hours. I say, “Look, I am not interested in lending you money at the chump-change rate of 0.14% when I can keep it at the Fed and get 0.5%. I want 0.35%.”

In theory, the interest paid on excess reserves is supposed to provide a floor for the Fed funds rate but that is not exactly what is happening. The fact is that the Fed has almost completely lost control of Fed Funds.

In the past, Fed monetary policy was able to control rates with durations of less that one year. That means: Prime, commercial paper and Treasury debt with maturity less than or equal to 1 year. The rates on longer term debt was left to the markets. This includes home loan rates.

Why This May not Work.

One problem is the shadow banking system. This consists of hedge funds, money market funds, S&L’s, and any entity with significant cash which is not part of the Federal Reserve. The Fed could counter this problem with reverse repos which essentially act like overnight loans to non-Fed entities. This would include the GSE’s (FNMA and FHLMC) and, in effect, could allow the Fed to influence mortgage rates by the reverse repos they do with the GSE’s. The point for those interested in how mortgage rates will be affected by changed policy is that it is not so much the Fed Funds rate but rather the reverse repo operation which will affect FNMA and FHLMC rates. This makes rate direction less predictable at least as to how rates are affected by Fed policy.

To be clear: I am not saying that the Fed should or will increase rates now. I am saying that they have floated the idea that when they do it may be in the manner discussed above. If this works it will have at least two effects: 1)short term borrowing rates will increase and 2) savings rates should increase.

The problems created by such a policy will, I believe, not be economic by political/social. The perception will be that this is being done to harm borrowers and benefit the wealthy who are savers. No one will remember that borrowers have had access to very low rates for the past 8 years. People who polemicize banks will point out that the Fed is paying about $5 billion a year in interest on those excess reserves. That is correct but it is also work noting that last year the Fed paid most of its profits to Treasury. That was about $77.7 billion. It is conceivable to me that the main effect could be to hurt the perception that politicians and the public have of the Fed. Having politicians affect and restrict Fed policy is about the worst thing which could happen.

The economy at present resembles a stuck bolt. We tried the wrench – zero interest rates. We hit the wrench with a hammer – interest on excess reserves. We put a breaker bar on the wrench and stood on it – QE but the bolt remains stuck. To be clear I regard 2.0% GDP growth as “stuck.” Will increasing interest rates on excess reserves be the WD-40 which gets the economy growing again? I have no idea and frankly I don’t believe that anyone else does.

At present Fed policy is perhaps best summarized by the words on the back of paper currency “In God We rust.”

 

 

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