The New Phantom Fed Funds Rate

Posted by Equity Private, Oct 07, 2008, 10:17am

The various appendages of governmental and quasi-governmental bodies intertwined with capital markets in the Unites States lurch about to and fro so suddenly, it's difficult to keep much of a fix on any of them. I am fairly sure that the Government Printing Office hasn't made some dramatic announcement declaring that, from here on out, they will accept old copies of the Beige Book as collateral for one or another liquidity enhancement program, but I'm keeping an eye out all the same.

With the chaos and the response thereto, a few things have gotten lost in the shuffle. Or at least left unattended. Say, for example, the news that the Federal Reserve will pay interest on reserves. In essence, this mitigates the trade-off the Fed faced between maintaining the fed funds rate in even remote proximity to its target rate, and undertaking a massive balance sheet expansion.

Given all the liquidity being thrown around, the rate at which the Fed plans to pay, to put it mildly, of interest. Remember this little burst of sudden avarice the next time a candidate for high office tells you that you should want the national savings rate to go up.

Of course, what interest scheme would be complete in the absence of a "fair and balanced" weighting and calculation methodology? Throw in the average Fed funds target rate, pull ten basis points, and you get something like 1.8% right now. Required reserves are, of course, a drain on banks. Paying interest on them is akin to a subsidy for the banks. An equally convoluted formula computes the interest paid on non-required (excess) reserves, that figures out to something like 1.15%. (I don't have exact data on the two week averages). Ladies and Gentlemen, meet your new fed fund rates minimum.

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