Fed Changes Interest Rate Formula Applied to Reserves
Today, the Fed changed the recently instituted formula for determining interest payment for reserve balances of banks held at the Fed. As of reserve maintenance period starting November 6, required reserves will be paid the average target federal funds rate and excess reserves will be paid the lowest target federal funds rate for the reserve maintenance period. In other words, there will be a difference in the interest rate paid on required and excess reserves only if the Fed changes the federal funds rate during the two-week period. The changes of the formula to determine interest payments for required and excess reserves are listed in Table 1.
These changes have been brought about because of the inability in recent weeks to manage reserves such that the effective federal funds rate is close to the target federal funds rate (see chart 1).
The federal funds rate has traded below the target rate every single business day from September 19, 2008. The spread between the effective federal funds rate and target federal funds rate has ranged in the negative territory from -4 bps to -133 bps since October 1, 2008, with two exceptions on October 7 and 8, 2008 when the effective federal funds rate was above the target federal funds rate (see chart 2). Excluding these two observations, the median spread between the effective and target federal funds rate is a hefty -71 bps. The policy to compensate reserve holdings was changed from the date authorized by the Financial Services Regulatory Relief Act of 2006 (October 1, 2011 was the planned date when the Fed would commence paying interest for bank reserves held at the Fed) in the process of handling the current financial crisis. Following this change, the formula now has undergone two alterations, implying that the Fed is finding its way in the management of the federal funds market.
The large changes in the Fed’s balance sheet to provide liquidity and maintain the working of financial markets is the reason for the current variations in the effective federal funds rate. Total assets of the Fed has been stable since the crisis began in August 2007 but is has grown sharply since September 2008 (see chart 3). Total assets of the Fed for the week ended October 29, 2008 stood at $1.97 trillion, up from September 3, when it was $905.661 billion - a staggering increase in eight weeks.
Borrowing from the discount window at the Fed and the different new programs such as TAF, PDCF, and asset-backed commercial paper money market mutual fund liquidity facility (see chart 4), the credit extended to AIG and aid related to Bear Stearns are factors that have led to the vast change in the Fed’s balance sheet.
The Fed sold Treasury securities and sought the help of the Treasury under the Treasury’s supplemental financing facility to sterilize its actions undertaken to provide liquidity support to banks. The success of sterilization is visible in the quantity of excess reserves (see chart 5). The sales of assets to maintain reserves were successful for an extended period but excess reserves started advancing as of the week ended September 17, 2008 (see chart 5) and the effective federal funds rate was noticeably below the target rate (see charts 1 and 2). The new policy to pay interest for bank reserves was expected to aid in holding the effective federal funds rate close to the target rate. As excess reserves began to grow sharply and the effective federal funds rate continued to hold far below the target rate, the Fed is making another attempt to bring the effective federal funds rate close to the target federal funds rate.
ISM Non-Manufacturing Survey – October 2008
The ISM Non-Manufacturing Survey results show broad based weakness. The headline composite index dropped to 44.4 in October from 50.2 in September. This is the lowest in the short history of this index (chart 6). Indexes tracking new orders and employment also fell sharply (see chart 7). The results of the ISM non-manufacturing survey confirm the message of a fundamentally weak economy seen in other economic reports.
