Fed's cash injections risk eclipsing main interest rate

By Craig Torres
Bloomberg News
Wednesday, November 19, 2008

http://www.bloomberg.com/apps/news?pid=20601087&sid=abYTR9BqGlBo&refer=home

WASHINGTON -- The Federal Reserve's efforts to rescue the U.S. from financial collapse risks the eclipse of the central bank's benchmark interest rate as the most important signal of monetary policy.

Record injections of liquidity have driven the overnight lending rate between banks to less than half the 1 percent target set by officials last month. The gap is shifting investors' focus toward the amount of money in the banking system as a better gauge of Fed intentions.

The Fed's failure to meet its target risks pricing billions of dollars in short-term debt at interest rates lower than the Federal Open Market Committee intends. It also makes it harder for traders to bet on the central bank's future course of monetary policy.

"A major signal of Fed policy intent, the effective funds rate, has become irrelevant," said Stan Jonas, who trades interest-rate derivatives at Axiom Management Partners LLC in New York.

Fed Vice Chairman Donald Kohn said today the central bank is simultaneously reducing interest rates and expanding its balance sheet in quantitative easing, while not adopting one strategy "in favor of another."

"We are lowering interest rates, lowering our target rate, and at the same time engaging in a great amount of liquidity provision to the system," Kohn said in response to a question at the Cato Institute's annual monetary conference in Washington. The Fed's tools to stabilize the fed funds rate haven't so far succeeded, he said.

... 'Policy Shift'

"There has been a policy shift, but the Fed is not transparently announcing what it is doing and why," said former St. Louis Fed President William Poole, now a senior fellow at Cato. "Monetary policy works best when the markets understand what the central bank is doing."

Some analysts point to the surplus cash that banks keep on deposit at the Fed as a key gauge of the Fed's monetary-policy stance. The so-called excess reserves have ballooned to $363.6 billion from $2 billion in August as the Fed added to its emergency lending programs.

"It is a move to quantitative easing, to force lots and lots of reserves into the banking system with the expectation that banks will start to trade them for a higher-yielding asset," said Poole, a Bloomberg contributor, said yesterday in a Bloomberg Television interview.

The risk is that banks fail to lend some of the excess reserves to businesses and consumers, prolonging the credit freeze that's led to recessions in the world's major economies. That's what happened in Japan after the Bank of Japan adopted quantitative easing in 2001.

... 'Banks Aren't Lending'

"The reason we put those reserves out there is in effect a response to the fact that banks aren't lending to each other and they are not lending to the private sector," Kohn said today. "We have had to interpose our balance sheet to where private balance sheets would ordinarily would be."

Excess reserves are now bigger than the overnight lending market between banks, called the federal funds market, where the Fed sets its key rate target. Fed officials may provide more information on the $250 billion federal funds market to help address the communication issue. Officials may discuss the matter at their next meeting on Dec. 16.

Bernanke said in a congressional hearing yesterday that the expansion of the Fed's balance sheet "makes it more difficult to control the federal funds rate." It is "still an issue we are working on," he told the House Financial Services Committee.

... Effective Rate

The effective federal funds rate was 0.38 percent Nov. 18, and has averaged 0.29 percent since the Federal Open Market Committee cut the rate to 1 percent on Oct. 29.

The sustained gap means the futures market for the federal funds rate is less predictive of the next policy move. Traders must now bet on how much the Fed will miss its target and where policy makers intend the rate to be in the future.

"It is now a two-factor world if you trade fed funds," said Brian Sack, vice president at Macroeconomic Advisers LLC in Washington and a former staff member of the Fed's Monetary Affairs Division. "You not only have to get the target right, but you have to figure out the expected miss."

Fed credit, a measure of how much money the central bank has injected into the economy, has expanded $1.3 trillion over the past year. The central bank has opened four facilities to spread cash around the banking system or provide corporations with backstop financing.

... Abandon Target

Typically, when central banks launch explicit quantitative easing strategies they abandon the interest-rate target and start purchasing assets to pump up the supply of money. There can be two effects on the economy.

Banks can decide to earn more than the 1 percent they earn at the Fed and start lending aggressively. That hasn't happened yet. Measures of bank reserves are growing faster than measures of money. Second, the Fed could target some asset that has a broad impact on the economy, such as Treasuries or bonds backed by mortgages.

Fed officials have already taken a half-step in that direction by purchasing the commercial paper of U.S. corporations at predefined rates. The central bank's Commercial Paper Funding Facility held $256.1 billion as of Nov. 12.

"They are not seriously targeting the funds rate anymore," said Stephen Stanley, chief economist at RBS Greenwich Capital Markets Inc. in Greenwich, Connecticut. "I would say that is exactly the right call. You want to provide maximum liquidity" in times of economic stress, he said.

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