Why the Fed Can't Do What It Wants to Do
Since September 18 last year, the Fed has pushed a low interest rate policy. The federal funds rate target has been lowered from 5.25% to 2.25% currently. Despite this, liquidity conditions in credit markets have continued to deteriorate. The extra yield investors demand in return for holding corporate paper rather than risk free Treasury debt has been increasing sharply since August last year.
For instance, the differential (spread) between the yield on the 90-day AA financial corporate paper and the 3-month Treasury Bill jumped to 1.224% in March from 1.177% at the end of February — in January last year the differential stood at 0.1%. The differential between the 90-day AA corporate asset backed paper and the 3-month Treasury bill rose to 1.484% from 1.357% at the end of last month. In February last year the differential stood at 0.08%.
A major reason for the widening in the yield spread is the Fed's policy of targeting the federal funds rate. It is this policy that has so far prevented the Fed from lifting the rate of growth of money supply, the key for the expansion in monetary liquidity and the narrowing in the yield spreads. Here is why.
Monetary Liquidity and Federal Funds Market
We define monetary liquidity as the differential between the supply and the demand for money. For a given demand for money an increase in supply leads to the increase in the differential, i.e., an increase in liquidity. Conversely, a fall in the supply of money for a given demand results in a fall in the differential and thus to a decline in liquidity.
An increase in liquidity as a rule benefits financial markets first and after a time lag various other markets (financial markets are the early recipients of the newly pumped money). An increase in liquidity means that people now have more money than they demand. This leads to the buying of various financial assets that pushes these asset prices up and lowers their yields.
The key then for the increase in monetary liquidity and the narrowing of the yield spreads is an increase in money supply relative to the increase in the demand for money.
The main market through which the Fed adds or takes money is the federal funds market. The federal funds market means a market for federal funds. What are federal funds?
Depository institutions such as commercial banks keep a portion of money that was deposited with them at the Federal Reserve (Fed). (Banks don't earn interest on their deposits held at the Federal Reserve.)
The money that commercial banks keep with the Fed is commonly known as reserves. Banks are required to have enough reserves in order to meet their legal reserve requirements and in order to be able to clear financial transactions. In short, when checks written against a bank are presented, the bank must have the money to honor the checks.
On any particular day, there are some banks that have more reserves than they are require, i.e., they have a surplus of reserves. Conversely, there are banks that have far too little reserves, i.e., they have a deficiency of reserves. The fact that some banks have excess reserves and some other banks have a deficiency sets a platform for a market for these reserves, which are labeled federal funds.
Federal funds can be borrowed only by those depository institutions that are required to hold reserves with the US central bank. They are commercial banks, savings banks, savings and loan associations and credit unions. The interest rate charged for the use of federal funds is called the federal funds rate. This rate is predominantly applied to short-term lending, mostly on overnight loans.
How Does the Fed Pump Money?
The US central bank exerts a direct effect on the quantity of money in the economy by buying or selling assets. For instance, the Fed buys an asset, such as government bonds valued $1 million from an individual Joe. The Fed pays for these bonds by writing a check against itself. Joe, the receiver of the check, places it with his bank, let us say Bank A. As a result of this transaction, Joe's demand deposit at Bank A increases by $1 million. This means that the money supply has increased by $1 million. Also note that the new $1 million has emerged out of "thin air" — the Fed has created the money by writing a check on itself.
In the next step, Bank A presents the check to the Fed. The Fed honors the check by raising Bank A's deposit at the central bank by $1 million. What we have here is an increase in Bank A's deposit with the central bank — an increase in Bank A's reserve balances to the tune of $1 million.
While buying assets by the US central bank raises money supply and depository institutions reserves, the selling of assets produces the exact opposite. For instance, the Fed sells $1 million of government bonds to Joe. Joe pays by check issued by Bank A. Once the check is cleared, Joe's demand deposit at Bank A falls by $1 million — the money supply falls by $1 million. Bank A's deposit with the Fed also falls by $1 million — Bank A's reserves fall by $1 million too. From what was said so far, we can establish that through buying and selling assets, the Federal Reserve is the key source of changes in money supply.
Interest Rate Targeting and Monetary Liquidity
In the present setup, the Fed is not aiming at directly influencing the money supply. Instead the US central bank is aiming at bringing the federal funds rate to a particular level, or a target. The underlying view here is that through the targeting of the federal funds rate, the US central bank can bring the economy onto a stable noninflationary growth path. Once the target is set it is then the role of the Federal Open Market Desk to make sure that it is met on a daily basis.
As a rule once the new federal funds rate target is announced the market tends to bring the federal funds rate towards the announced target in anticipation that the Fed will be successful in achieving the goal. According to the head of domestic reserve management at the New York Fed Sandra C. Krieger,
If the rate does not move quickly to the new target, the Desk might supply more or fewer reserves on a particular day in order to make it move.
The main task that Fed operators are assigned with is to successfully maintain the federal funds rate at the announced new target. To succeed in this task the Fed's Open Market Desk is continuously on the lookout for various factors that could disrupt the balance between the supply and the demand for federal funds. Once these disruptive factors have been identified, Fed operators counter them by means of buying or selling assets in the market.
A major factor that creates disruptions in the federal funds market is the activity of the US Treasury. The US Treasury maintains working balances at the Federal Reserve for making and receiving payments. For instance, when individuals are paying taxes to the Treasury, this leads to the withdrawal of money from banks and to the increase in Treasury balances held with the Fed. In short, as a result of tax payments, the reserve balances of depository institutions at the Fed decline by the amount of tax paid to the Treasury.
It follows that tax payments lead to the fall in the supply of reserves in the federal funds market. A fall in the supply of reserves, all other things being equal, puts an upward pressure on the federal funds rate.
In order to prevent the rate from over-shooting the target, the US central bank is compelled to pump money by buying assets such as Treasury securities in the market. The pumping of money lifts the level of banks reserve balances at the Fed; the supply of federal funds is raised and the upward pressure on the federal funds rate is removed.
The payment of taxes that causes a decline in the supply of reserves in the federal funds market doesn't have any effect on the money supply. When Joe pays $1000 in taxes to the Treasury, $1000 is transferred to the Treasury — there is no change in the money supply. Yet the US central bank, in order to keep the federal funds rate in line with the target rate, is forced to pump new money. In short, paying taxes results in an increase in the monetary injections by the Fed.
The Fed will also inject money to the federal funds market if individual demand for currency, i.e., cash, is rising. For instance, on account of an increase in economic activity, Joe has decided that he needs to hold in his wallet an extra $500. In short, Joe withdraws from his demand deposit $500 in cash. All that we have here is that instead of holding the $500 in demand deposits, Joe keeps it now in his wallet.
There is no change in the money supply on account of Joe's withdrawal of $500. To accommodate Joe's demand for $500, Bank A has transferred this amount from its reserve account with the Fed. This means that because of the increase in the demand for cash, the banks' reserve holdings at the Fed have fallen by $500.
As a result of the fall in the supply of reserves in the federal funds market, the federal funds rate tends to increase. To keep the federal funds rate in line with the target the US central bank will pump money by buying assets.
Conversely, on account of a decline in economic activity, or for some other reasons, Joe concludes that he requires $500 less to hold in his wallet. This means that he deposits the $500 with his bank. This transfer of cash into demand deposits also boosts Bank A's stock of reserves by $500. So what we have here is an increase in the supply of reserves in the federal funds market, which now exerts a downward pressure on the federal funds rate.
To prevent the rate from falling to below the target, the Fed is forced to reduce the supply of reserves by taking money from the economy through the selling of assets.
It follows, then, that changes in economic conditions that disrupt the balance between the supply of and demand for reserves force the Fed to interfere to prevent the federal funds rate to deviate from the target. In short, the US central bank is compelled to either take out or add money to the economy.
Now it can occur that despite a seemingly loose interest rate stance, as we have it currently, on account of weak economic activity, the Fed actually remains tight as far as money pumping is concerned.
We have seen that a lowering of the federal funds rate target doesn't require a massive pumping of money — at best just a slight push. Once the lower target is established, the Fed cannot, "just like that," push more money into the economy. If the Fed were to do that, the federal funds rate would fall strongly below the target.
In order for the Fed to be able to increase the monetary pumping, there must be a suitable trigger, such as an increase in the demand for currency by the public or an increase in Treasury's tax receipts from the economy. In both cases the Fed would be compelled to pump money to prevent the federal funds rate from overshooting the target. Because of a weakening in economic activity, this is currently not the case.
After climbing to 7.2% in Q2 2004 the yearly rate of growth of nominal GDP fell to 5.2% by Q4 2007. We suspect that once economic activity starts to weaken both demand for currency and the inflow of tax money to Treasury also tend to weaken.
Since November 2004 the growth momentum of demand for currency by the public has been on a decline. The yearly rate of growth fell from 6% in November 2004 to 1.4% in March this year. Likewise the growth momentum of the US Treasury deposit at the Fed has been in decline. The six-month moving average of the yearly rate of growth fell from 25.5% in April 2007 to 0.3% in March this year.
As a result, the Fed was forced to actually slow down its monetary pumping to prevent the federal funds rate falling below the target. In short, a fall in economic activity caused the Fed to exacerbate the liquidity crunch.
The latest data of the Fed's monetary activity shows that the yearly rate of growth of the central bank balance sheet stood at 2.3% in March against 4% in September last year. Consequently, the differential between the growth momentum of Fed assets and the growth momentum of nominal economic activity (a proxy for demand for money) has been also subdued (see chart on the right below). In short, monetary liquidity is currently not responding in a way the Fed regards as favorable.
A fall in the growth momentum of the Fed's balance sheet is the key reason why monetary liquidity is still depressed despite the very easy interest rate stance of the Fed. It is for this reason that interest rate spreads have continued to widen.
In order to have a narrowing in the spread, it is necessary to increase monetary liquidity, i.e., the increase in the growth momentum of the Fed's balance sheet. For the time being, given the weakening in economic activity, this is not easily done. Obviously, if the Fed were to decide to set the interest rate target to nil, then it could have the freedom to pump as much money as it likes. But by doing that it runs the risk of seriously undermining the bottom line of the economy.
Also, contrary to popular belief, the policy of setting and bringing the federal funds rate to a particular target rather than producing economic stability generates the exact opposite result. We have seen that to maintain the target the Federal Reserve must offset various disruptions in the federal funds market by buying and selling assets, i.e., by varying the pace of monetary pumping. It is this variability in the pace of the Fed's pumping, which is manifested through changes in the Fed's balance sheet, that is at the core of the boom-bust cycle menace (see chart).
Despite the very easy interest rate stance of the US central bank, liquidity conditions in credit markets have continued to deteriorate. We suggest that Fed actions that are aimed at meeting a given federal funds rate target coupled with weak economic activity make it difficult to lift the level of monetary liquidity.
The fact that the Fed has failed to boost monetary liquidity is bad news for sectors affected by financial bubbles. In contrast, a fall in the growth momentum in the Fed's monetary pumping is good for wealth-generating activities.
A subdued pace of monetary pumping means that the pace of the diversion of real savings from wealth generators to nonproductive activities is declining. As economic activity starts improving, this should make it easier for the Fed to lift the pace of monetary pumping, thereby improving monetary liquidity. The increase in monetary pumping however sets in motion a new boom-bust cycle. Also, once economic activity starts to recover on its own (as a result of the improvement in the pool of real funding) any "help" from the Fed can only slow down the process of recovery.