Friday, November 21, 2008

Fed liquidity flood swamps rate controls - FT

By Krishna Guha The dramatic expansion of liquidity operations by the Federal Reserve is making it difficult for the US central bank to manage the federal funds rate, the basic interest rate in the US economy, as the minutes of its October policy meeting make clear. The flood of reserves created by the Fed since September has made the actual funds rate highly volatile and left it trading on average far below the target rate of 1 per cent. The problem highlights the challenge facing all the world’s central banks as they try to ramp up liquidity support and fill in for a dysfunctional interbank lending market by providing loans for periods of several months, without losing control of their basic interest rate in the process. The Fed, which until recently relied on old mechanisms to manage interest rates, has a new tool to tackle this problem – the ability to pay interest on bank deposits held at the central bank. These interest-bearing accounts suck excess reserves out of the market. But while this is helping, market dislocations have prevented it from working as smoothly as hoped. The US central bank has already had to retune this facility twice in a matter of weeks and may have to make other changes, including finding an indirect way to pay mortgage groups Fannie Mae and Freddie Mac interest on their reserve holdings. Prior to the credit crisis, the Fed managed the Fed funds rate through open market operations – estimating how much demand there would be for reserves each day, the supply required to meet this demand at the target interest rate, and adding or subtracting reserves from the market accordingly by buying or selling US government securities. After the crisis began in August 2007, the US central bank used these open market operations to suck out excess reserves created by its new liquidity operations. But these operations, which grew more difficult as the liquidity operations swelled, became unmanageable from September of this year, with huge further increases in liquidity support that created reserves on a giant scale. The US Treasury stepped in to help by issuing about $500bn in what were, in effect, sterilisation bonds intended to mop up the excess reserves created by Fed lending. However, this was only a stopgap measure. Ben Bernanke, the Fed chairman, believed that the real solution lay in the ability to pay interest on reserves, which would put a floor under the actual fed funds rate. This authority was granted by Congress as part of the $700bn bail-out plan, since when the Fed has been able to ramp up its liquidity operations still further, with unlimited swap lines to a number of other big central banks and large-scale purchases of commercial paper. Yet, while the ability to pay interest on reserves has helped the Fed expand lending without completely losing control of the Fed funds rate, it has not prevented the actual rate from consistently undershooting the target rate, forcing the Fed to twice amend the way it operates. Initially the Fed hoped to use the deposit rate on reserves to establish a corridor around the Fed funds rate, using it as a backstop for its traditional open market operations, loosely following the model used by Canada and Australia. So it set the deposit rate 65 basis points below the target Fed funds rate. But the actual Fed funds rate simply sank to the deposit rate – the bottom of the Fed’s new corridor. So the Fed was forced to narrow the gap, reducing the spread so the deposit rate was set at 35bp below fed funds. The actual Fed funds rate still sank to – or even below – the new deposit rate. So the Fed last week dropped the gap altogether, announcing that it would set the deposit rate equal to the Fed funds rate – loosely following the model used by New Zealand. That, in theory, should have stopped the Fed funds rate falling below target, because banks would not want to lend money to each other in the overnight Fed funds market for less than they could get with no risk by putting their money on deposit at the Fed. Yet the Fed funds rate still sometimes trades below target. Fed officials believe this is in large part because Fannie Mae and Freddie Mac, which account for between a third and a half of the Fed funds market, and a still larger proportion of net lenders of reserves, cannot by law directly receive interest on reserves from the Fed. In a normal market this would not be a problem, because banks would queue up to act as intermediaries for Fannie and Freddie. But banks are not doing this, apparently because they are too capital constrained to swell their assets with Fannie and Freddie’s excess reserves. So the two enterprises continue to loan funds at less than the target Fed funds rate, allowing the actual interest rate to trade below its target. The Fed is now looking at ways to overcome the Fannie/Freddie problem – for instance, by inducing a bank to act as an intermediary – in the hope that resolving this will finally restore their ability to tightly control US interest rates.

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