WHAT IS THE FEDERAL RESERVE DOING?
Targeting or Setting the Funds Rate
By Wayne Jett
© September 4, 2007
The interest rate charged by the Federal Reserve to banks who apply for collateralized loans at the Fed’s “discount window” was reduced 50 basis points by the Federal Reserve in August. The discount rate is actually set by the Fed as the interest rate acceptable for loans it makes to member banks.
The Fed’s funds rate, on the other hand, is the interest rate charged by member banks to each other for overnight loan of funds held in reserve at the Fed. The Fed chooses a target rate of interest for such overnight loans so as to optimize the goals of monetary policy. By past accounts, the Fed reportedly causes member banks to charge the target rate by adjusting the amount of cash available to those banks in reserves through buying or selling securities owned by the banks, thus making those overnight loans easier or harder to come by. In doing this, the Fed is said to “tighten” or “loosen” monetary liquidity by injecting or draining liquidity for the private economy. But is that really the case?
Evidence Funds Rate Is Set
Though incomplete and inconclusive, evidence is mounting that the Fed’s funds rate target is actually a set rate and not really the Fed’s instrument for conducting policy. If it is a set rate, the funds rate is not really determined by competition among banks for available overnight reserves. Whether this is true is significant in forecasting the effects of Fed policy, particularly when other Fed operations move contrary to the funds rate.
Throughout the period of funds rate increases between June, 2004, and June, 2006, the Fed injected permanent liquidity into the economy by buying Treasury securities for its portfolio with newly created currency. These open market activities simultaneously reduced economic growth and demand for the dollar (via the funds rate increases) while adding more currency to chase the shrinking supply of goods and services. With demand for dollars declining as the supply of dollars rose, excess liquidity soared and the dollar’s unit value could only retreat.
Indeed, the dollar fell sharply relative to gold, as the gold price rose from under $400/oz before the funds rate target hikes began in June 2004 to a peak of $735/oz in May 2006 as doubts grew about whether the hikes would ever end. The dollar’s fall signaled the rise in liquidity, disproving the “tightening” voiced by Fed and financial market observers. With liquidity soaring, logic advises that the overnight funds rate should have declined as member banks competed with plentiful reserves. That it did not raises the question: why?
By Fed theory, the funds rate moves inversely with liquidity; the funds rate rises when liquidity falls and vice versa. That the funds rate remained on target while liquidity soared means the funds rate, like the discount rate, is actually set by the Fed and is not dependent upon liquidity.
August Liquidity Injections
Additional evidence that the funds rate is set, rather than targeted, came in August when the Fed injected liquidity in response to perceived credit dislocations. On August 10, the Fed announced it was “…providing liquidity to facilitate the orderly functioning of financial markets.” On that date and subsequent occasions, the Fed injected temporary additional liquidity by buying “re-po” contracts. On each occasion, brief degrees of erratic movement in the funds rate was noted, but rate promptly resumed the target level even as the added liquidity remained in the system. This pattern does not call to mind robust competition among banks determining the overnight rate for reserves. Of course, banks did not vary their prime rates or other loan rates payable by their customers.
Nineties Deflation vs. Recent Inflation
Circumstantial evidence that the funds rate is set by the Fed comes from the fateful, deflationary period of 1996-2002, when the dollar’s value rose from a gold price above $400/oz to a peak of $252/oz in 1999. The deflation collapsed commodity prices by 1998 and the smaller, dollar-borrowing economies of Asia, and then attacked and demolished the larger U. S. financial markets in 2000-2002. The sharp increase in the dollar’s unit value caused prices of goods and services to be reduced. This destroyed profitability and made repayment of loans more burdensome and highly problematic. The point to be made here, however, is that the sharp deflation of 1996-2000 occurred in the monetary environment of high and rising funds rate targets. The target ranged from 5% to 6.25% from late 1994 until October, 1998, when it briefly dropped to 4.75% until July, 1999, when it moved back to the higher range of 5% to 6.5%. There it remained (except for the brief Y2K episode at year-end 1999), still at 6.5% near year-end 2000, without moving below 5% until April, 2001. At the time, the dollar remained overly strong (deflated) at about $275/oz. The conundrum presented juxtaposes the severely strong (deflated) dollar of 1996-2002 in contrast with the sharply weaker (inflated) dollar of 2004-2007, with the two dramatically different monetary results produced by essentially equivalent funds rate policy. In 1996-1999, the dollar’s value rose from $400/oz to $252/oz; in 2004-2007, its value has fallen from $400/oz to $665/oz.
The answer to this dichotomy must be that the Fed manages liquidity by means other than the funds rate target. Fiscal conditions in the two periods were largely comparable, since 1997 provided a cut in the tax rate on capital gains and 2003 a cut in marginal tax rates on income. Both tax cuts produced greater demand for dollars to invest in production, so each would absorb liquidity and tend to strengthen the dollar. During 2004-2006, however, the Fed injected new liquidity into the economy by continuously buying Treasury securities, even as it slowed economic growth by raising the Funds rate. In those three years, the Fed bought $50 billion, $25 billion and $34 billion in Treasury securities, plus transferring funds in similar amounts annually to the Treasury directly, free of charge, as distribution of “excess earnings” on its portfolio of Treasuries. These recent actions by the Fed explain the dollar’s current weakness.
What explains the dollar’s excessive strength in 1999? By definition, the dollar’s dramatic rise in value relative to gold means that the Fed failed to provide adequate liquidity to accommodate economic growth during 1996-2002. The Fed has not released data reflecting its open market transactions during that period, so we do not know whether the Fed actually drained liquidity by selling Treasuries. Then Fed chairman Alan Greenspan acknowledged the Fed decided to take “pre-emptive action” against inflation in 1999, which likely indicates draining liquidity. Regardless of specific actions, by its liquidity management in 1996-2001, the Fed caused the dollar’s value to appreciate to such a degree as to dislocate markets and economies globally.
More pertinent to this discussion, the Fed produced two contrasting monetary results – a much stronger dollar and a much weaker dollar – while using its funds rate target in approximately the same manner. Thus, the funds rate target must not be the instrument by which the Fed produces its policy result. This may explain statements from some quarters in recent months that the Fed no longer uses the funds rate as its policy tool, and is managing the monetary aggregate base. If that is the case, then the Fed might do well to inform the public so observers could suggest desirable guideposts by which the Fed might keep the dollar’s value within a narrower range than swings of 50% or more up and down.
Bank Compliance With Set Funds Rate
The Fed announces its funds rate target and member banks comply by charging that interest rate for overnight loans of reserves. Why would banks comply with the Fed’s choice of a funds rate target? The Fed regulates the banks in many important respects, so banks do not offend the Fed with impunity. More importantly, the higher funds rate serves the banks’ own interests as a benchmark for their loans to customers, large and small. Banks comply with the funds rate target (a minor matter) and, by doing so, achieve an industry-wide foundation for charging higher interest rates to their borrowers (a major matter). As the Fed announces a funds rate hike, each bank knows competing banks will raise lending rates at the same time. This protects against loss of banking customers through competition. So the funds rate could be a de facto “set” rate, even if not announced as such.
Though the Fed’s apparent deception is unsettling, its move away from sole reliance on the funds rate target signals progress toward sound policy. The next step should allow the funds rate to float in actual competition. Then the only further adjustment necessary would be use of the gold price as guide to whether liquidity should be added or drained. ~