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August 15, 2007
Strange things in the fed funds market
Felix Salmon shows that the effective fed funds rate has dipped below 4.75%. Of course, given Friday's events, one would have expected the effective rate to have been low. Even Monday I can understand. But this seems to be lingering more than many would have expected. What's up?
First, let's do a graph showing not just the effective rate, which is a weighted average, but also the range. (Data)
And now we see the larger picture. The reason for that the effective rate has dropped a bit is because there are a few trades at very low (zero for Friday and Monday) interest rates. The high end of the range is right where you would expect it to be--consistent with the last month or so. But why the trades at or close to zero?
Remember, the Federal Reserve does not control this rate precisely. Also, even under normal conditions, the funds trade in a range. Creditworthiness of the borrower matters for a few basis points. So what the Fed does under normal circumstances is to try to get the weighted average... the preponderance of the trades, if you will... as close to the target as possible. It is quite normal to miss by a couple of basis points, but it's a testament to the institutional knowledge of the trading desk in New York that they can get it that close day in and day out.
Remember also that this infusion of liquidity represents reserves, or base money. It doesn't get multiplied through the deposit process unless banks lend those reserves to create new deposits. Something tells me that's not going to be an enormous risk in this case. Intermediaries are more likely to be carrying some excess reserves at this point. And they earn zero interest on those reserves. Hence, it's not entirely out of whack that at a time like this the market rate on those marginal excess reserves is significantly lower than the target. But zero?
Here's what Reuters had to say:
DOWN TO ZERO: According to data from The Federal Reserve Bank of New York, federal funds low trade of the session on both Friday and Monday was zero percent. On Friday, the highest traded intraday level was 6.05 percent, while Monday's intraday high was 5.5 percent.
Market analysts said the low trades showed that the Fed's liquidity infusions had been enough to bring down the cost of overnight money steeply as volume thinned in late afternoon trade. Data for federal funds on the New York Fed Web site goes back to January 2000 and shows that federal funds have not traded at zero before then, although they have come close.
In the aftermath of the Sept. 11, 2001 attacks, fed funds traded at 0.06 percent according to Federal Reserve data. In August 2004, fed funds traded at 0.03 percent.
A zero intraday trade for federal funds may be an even rarer event, analysts say.
"I find no evidence of federal funds trading at zero at any time since at least 1988," said Tony Crescenzi, chief bond market strategist, Miller, Tabak & Co. in New York.
So while I don't have a full and definitive explanation, it would seem that borrower risk is a factor, and the fact that these are excess reserves (which earn no interest) is also a factor. In that case, the low end of the range could stay low until the reserve picture gets back to normal. Soon we should get some data on excess reserves, which may shed some light on this situation.
In other words, I don't see this small fraction of trades at such a low level as being inflationary. Quite the contrary, if intermediaries want to hold more excess reserves as a risk management measure then the Fed is doing the right thing by offering those reserves. It only becomes a problem if those intermediaries run out and make more questionable loans with the money. I don't see that happening, and if it does, then (a) we'll call them on it, and (b) the Fed will likely pull back those reserves. Wouldn't you want intermediaries to respond to the recent turmoil by holding excess reserves? If so, then I wouldn't get worked up by some fed funds trading on the low side, even significantly on the low side.
I would suspect that it will creep slowly away from zero over the next few days (barring any other events), but the standard deviation is likely to remain higher than it was just a couple weeks ago.
Back the Reuters piece referenced above, this should also help:
SUPPLY: Issuance of Treasury bonds and notes can put upward pressure on federal funds, bond analysts say. For example, the settlement of last week's 10-year Treasury note and and 30-year Treasury bond auctions this week could put upward pressure on federal funds, said Josh Stiles, bond strategist and managing director with IDEAglobal in New York.
And of course, the Fed knows that and would have taken it into account when it made the 14 day repo last Thursday.
So don't get the impression that the funds rate has gone down in any meaningful sense until we see what the excess reserve picture looks like.
UPDATE: Tim Duy has some comments on this and on St. Louis Fed President William Poole's interview with Bloomberg. For the record, I agree with Tim that the temporary nature of most of the injection is the main reason that this is not inflationary. But I think the main reason we're seeing a few fed funds trades near zero interest is that those are the marginal trades of excess reserves. That intermediaries appear to be holding excess reserves even after much of last week's injection has been reversed is significant. This also puts some downward pressure on inflation if that practice continues.
UPDATE 2: The Fed injected another $12 billion in a 1 day repo and $5 billion in a 14 day repo this morning. The 14 day repo will correspond with the 14 day maintenance period for reserves which begins today. The Fed also announced that with the new maintenance period starting, they may need to inject more reserves but that should not be interpreted as a sign of a problem. For more, see this Wall Street Journal piece.
Posted by William Polley at August 15, 2007 08:17 PM
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