Monday, February 10, 2014

Chicken and Egg, Part II: A Primer on the Fed Funds Rate

The Federal Reserve's bread and butter policy tool is the Fed Funds rate (FFR).  This simple interest rate that banks lend to each other at to satisfy the reserve requirement and withdrawals is closely watched by the most powerful individuals on Earth. Thus, it is important to understand at least the basic mechanism under which this system operates and dispel some of the wild rumors surrounding the admittedly mysterious Federal Reserve.

In a nutshell, this rate technically freely floats and depends on supply and demand.  However, the Fed can easily move the rate to a predetermined target by selling and buying government securities to and from the biggest financial institutions in the world (primary dealers).  When the Fed buys, it pays with reserves (combined with currency in circulation equals the monetary base) and thus reserves increase in the private sector, driving supply up and the rate goes down. If the Fed wants to raise this rate, it will sell securities and takes reserves from the private sector.  Reserves become rarer, supply goes down, and of course the rate increases.  Therefore, the addition/subtraction of reserves from primary dealers' balance sheets are a means to an end, the goal being nudging the interest rate to a predetermined target.  

Some people disagree as most economic textbooks paint reserves as the most important ingredient for credit creation--the more reserves, the more loans can possibly be made, and thus greater money supply.  However, this is incredibly misleading.  The amount of reserves does not change in aggregate when a loan is created.  Total reserves can only be increased or decreased by one of two ways.  First, the public can choose to hold more or less of the money supply in cash form (holding more decreases total reserves and vice versa for holding less).  Second and more importantly, total bank reserves move up and down in response to the Fed's buying and selling of government securities (open market operations).  In essence, bank reserves are always a policy tool to facilitate the Fed hitting its Fed Funds rate target.  The amount of reserves on a bank's balance sheet has no bearing on how much banks are willing to lend. 

FRED Graph
Seen here, the monetary base (red) is simply an accounting identity due to the assets on Fed's balance sheet, in this case Treasuries and mortgage backed securities (blue).  

Most people misunderstand this concept because of the reserve requirement, which is the percentage of reserves the Fed requires banks to hold against their customer's deposits.  Even though total bank reserves remain unchanged without Fed's open market operations (assuming the public's preference for physical currency doesn't change), the amount of reserves that are required increases as more deposits are created.  However, because the Fed has committed to target the FF rate, it will always ensure there are enough reserves to satisfy the reserve requirement and cash withdrawals.  As an example, suppose Bank A is running low on reserves due to burgeoning increase in loans and deposits (or withdrawals).  When it borrows from Bank B, this increases the demand for reserves, thus driving FFR up slightly.  Now assume this is a systematic issue: the FFR will increase even more dramatically, as the private sector is unable to create more reserves without the public suddenly depositing more cash.  However, since the Fed is targeting the FFR (assuming it does not want the FFR to change), it will have to inject enough reserves so that the rate comes back down to the targeted level.  Therefore, reserve requirements are almost always a negligible issue for banks.  They understand that the Fed is interested at defending a certain FFR and thus will always deliver enough reserves to make it so.

This leads to an interesting corollary: the sudden appearance of excess reserves in late 2008, coincidentally arriving the same time as FFR was targeted to between 0% and .25%, and Quantitative Easing.  If one understands the above, the existence of excess reserves should not be surprising.  First, total bank reserves exploded simply due to the Fed's historical buying spree.  However, without an increase in loans or deposits, required reserves has remained steady.  This leads to an interesting observation: there are never excess reserves above the reserve requirement unless the FFR is around 0%.  First, the chart of excess reserves:

FRED Graph

And now the FFR:

FRED Graph

When the FFR is unequivocally nowhere near 0%, it signals that the money supply is being constrained by lending institutions in the sense that banks lend first and get reserves later.  Operationally this makes sense, as the chart shows that since banks did not have excess reserves, it must borrow from another bank to satisfy reserve requirements.  However, since this extra demand would raise rates et ceteris paribus, the Fed will step in with just enough extra reserves (buy securities) to hold the FFR at its target.  This is how total reserves increase, but excess reserves remain at 0.  

However, when fed funds rate are around 0%, this implies that banks are literally lending money to each other for free and by extension this implies there are almost no demand for these reserves.  If there is no demand, this must also mean that at least in the near term, these reserves have to be excess reserves.  Therefore, this must mean that lending is bottlenecked by demand rather than supply.  There is simply a dearth of qualified borrowers as excess reserves should drop if borrowers are willing and able.  

FRED Graph
Loan growth remains anemic, hovering around 0%

Note that this is not to say there should be more people borrowing.  This is simply to point out there is more than enough supply of credit at extremely low interest rates.  Because the Fed can only effective set the price of credit and cannot force households and businesses to borrow, there is little else to be done by the Fed unless it chooses to completely shift its policy tools.

Some argue that Quantitative Easing is an example of such a shift, but it is exactly what the Fed has done since its creation--buying and selling government bonds to influence interest rates.  Its only difference is that they are a longer-termed variety as the Fed had hoped it can buy enough longer termed bonds to nudge longer term rates down as short term rates are all near 0%.  However, this has proven to be more difficult as longer term rates has an inflation variable, leading to the curious case where QE has sometimes caused intermediate and long term rates to increase as market participants began pricing in an economic recovery and inflation (which cause higher rates) against the lower supply of Treasuries (which cause higher prices and lower rates).

There has also been some brouhaha about the Fed paying interest on excess reserves (IOER).  As another unintended consequence, the Fed realized they were losing control of short term rates.  Suppose Bank A tries to lend these excess reserves to any other bank, but no bank has use for it because every bank already has enough reserves to satisfy the reserve requirement.  Thus these excess reserves has no demand and would drive the FFR to effectively zero.  This forced the Fed to pay .25% IOER: it has become the de facto fed funds rate.  Without the .25% and with the existence of excess reserves, FFR will always be 0%.  Even the IOER isn't without its wrinkles as the FFR hypothetically should never go below .25% as banks should always prefer to get .25% return rather than anything lower by lending their reserves to other banks.  However, current fed funds rate are around .08% suggesting there are other issues at play.  This recent paper explains the nitty gritty behind it as well as propose a few solutions.  Overall, this as well as the Fed's new reverse repo facility signal at least a continuation of excess reserves and probably a permanent large supply of excess reserves as the Fed changes the way it hits its short term rates targets.