Posted by Early November 2008
There is an old saying of be careful what you ask for, because one day you may actually receive it. I’m finding that out now, in spades! The good news, of course, is my promotion to the role of Domestic Money Markets Staff Coordinator and it seems like I have good staff both above and below me, so hopefully a clear career path to success. My promotion is part of a broader re-organization of the FRBNY Markets Group, so the dust is still settling to some extent. Once I get a handle on my new responsibilities, it should be smooth sailing for my career, but what has the Fed gotten into? I literally will have line responsibility for implementing monetary policy and a time when the monetary policy transmission mechanism may be breaking. Yikes! We have met the 1930’s, and they are us. !:-0
What is the monetary policy transmission mechanism? It’s a fancy term for how the central bank controls interest rates. In the US, the Fed has relied on a paradigm of reserve scarcity since at least the 1960’s (I think), in which the Fed controls the level of reserves to encourage banks to trade these reserves with each other at an interest rate that is close to the rate that the central banks wants, i.e. the “policy rate”. For quite some time, the Fed has expressed the stance of monetary policy using the target rate of overnight fed funds. In the fed funds market, banks trade reserves with each on an unsecured basis and the large majority of trades have an overnight maturity. During this time, the Fed did not pay interest on reserves but banks needed to hold reserves anyway to meet their reserve requirements and for transactional needs. When banks felt like they had too many reserves that would sell them in the fed funds market to earn some interest on this idle cash. Conversely, if banks had larger than expected outflows, they would borrow in the fed funds market to increase their reserves to the desired level. I have four and a half years of experience working on the Domestic Money Markets (DMM) desk from the pre-crisis era. Back then we used to make daily forecasts of both Supply and Demand in the fed funds market and we would make fine tuning adjustments in the level of reserves. If we got it “just right”, the weighted average rate for that day’s fed funds trading would come literally be “at the target rate”.
This monetary policy transmission paradigm worked very well, but it is being challenged in the current environment in which the Fed has launched a de facto policy of quantitative easing – i.e. intentionally flooding the market with electronic money / reserves. With all this newly created electronic money sloshing around, the Fed’s policy rate, the overnight fed funds rate, has started to trade at ultra-low rates, even as low as .01 (one basis point). An intended fix to this situation, paying banks interest on their reserve (IOR) balances, doesn’t seem to be working either. In late October, the FOMC cut the target rate from 1.50% to 1.00% and lowered the interest it will pay on reserves by 10 basis points, from 75 basis points to 65 basis points. That should help get the fed funds effective rate closer to the interest on reserves rate, but is it really “working”? Over the first week of November, the fed funds rate printed between 23 and 27 basis points, even though the target rate for fed funds was 1.00% and the Fed was paying 65 basis points on reserves. Hmm…..
Why are fed funds trading at such low rates? Well, in addition to the market being flooded by reserves, there is also a technical reason for the rate softness. Government Sponsored Enterprises (GSEs – Fannie, Freddie and the Federal Home Loans Banks) are participants in the fed funds market but are ineligible to receive the IOR compensation. As a result, these entities are willing to sell funds way below the IOR rate. The IOR rate was intended to be “floor” for trading rates in the fed funds market; believe it or not, now it’s not even a “ceiling”. Staying with this dynamic, banks now have NO incentive to be active in the fed funds market, except to try and borrow from the GSEs. Why make active two-way markets when you can just forget about the lending part and leave your money at the Fed and earn more money? Who said banking was difficult?
I used to think if everyone thinks LIBOR is so screwed up, why don’t market participants just rely on fed funds as their reference rate? (Fed funds is used as a reference rate in the interest rate swap market under the name Overnight Indexed Swaps, or OIS). Now that it’s apparent that the fed funds market is not functioning too well, I stopped asking myself that question and thank God that greater reliance did not happen. There may be one saving grace here, though. Very low overnight rates may encourage investors to extend the term of their investments in search of higher yields. This should bring LIBOR fixings down and improve market sentiment. In terms of actually encouraging lending and improving the economy though, who knows?
Late January 2009
Let’s see, what has happened since November? In no apparent order, stress continued to build in the banking sector and the US government created two institution specific facilities to support both Bank of America and Citibank, each of which provides a layer of loss protection for hundreds of billions of dollars of assets. Bank of America’s stock price has fallen as low as $5.00 a share, it was trading around $33.00 when they acquired Merrill Lynch over the “Lehman weekend”. Thank goodness B of A did not pay cash for their purchase of Merrill. Staying with Merrill for a minute, they just fired their “new” CEO, who must be thinking, “what a long, strange trip it’s been.” The previous CEO, Stan O’Neal, lost so much money for the firm it almost has to be criminal.
The United Kingdom’s banking system looks like its approaching complete meltdown. The market finally woke up to the fact that RBS and Lloyds have severe asset quality problems – even though they are both already majority owned by the government – and their share prices dropped precipitously in January. Hmmm. Barclays has not taken “bail out” money from the UK government but they are taking money from the United Arab Emirates. This latest deal seems to have an anti-dilution clause that may hinder them from raising funds in the equity market in the future, but I guess they’ll cross that bridge when they come to it.
Of course, financial stress can always be worse, unless you are the country of Iceland. They have just basically thrown in the towel and asked for IMF money, not to “bail out” their banks, which they can’t afford to do, but to make “cents on the dollar” payments to the holders of their bank liabilities. Apparently, the whole country is resigning itself to a becoming a barter economy and fish will be the main food source. Next sovereign to enter the financial crisis vise will likely be Ireland. The so called “Celtic Tiger” has guaranteed all of its bank liabilities and nationalized most of its banks. The problem is the banks were bigger than the country!
Meanwhile, back in the states, the Domestic Money Markets division continues to wander into unchartered territory, this time with me at the helm…scary! In the December FOMC meeting, the Fed made an historic change and set the policy target rate as a range of between 0 and 25 basis points (0 – 0.25%). “If you can’t have the target rate you want, then set the target rate to what you have”, or something like that. Finally, Tim Geithner, ex-President of the NY Fed, was confirmed as the US Treasury Secretary serving in the new Obama administration. Best of luck to him and congratulations on a job well done as president of the New York Fed during an historic time of financial stress.