15 Sep 2008

Fed Injects $70 Billion to Push Down Federal Funds Rate

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According to this CNBC article:

Federal funds traded in the U.S. interbank lending market slipped to about 4 percent from 6 percent earlier on Monday, after the Federal Reserve added $50 billion of temporary reserves to the banking system in a second overnight repurchase agreement.

Earlier on Monday, federal funds surged to 6 percent, well above the target rate of 2 percent that the Federal Reserve sets.

The earlier market move happened even as the Federal Reserve added $20 billion of temporary reserves to the banking system via overnight repurchase agreements.

This raises an interesting point: When the Fed “sets” interest rates, really that just means they pick a target rate (currently at 2 percent) for how much major banks charge each other for overnight loans of reserves. So the Fed itself isn’t a direct participant in this market; the federal funds rate is a market-determined one. The Fed does NOT “set interest rates” the same way that the government might “set the minimum wage” or apartment rates under rent control.

However, the catch is that the Fed ultimately controls the supply of reserves, and so it can indirectly move the “market”-determined federal funds rate. As the article above shows, the actual federal funds rate can sometimes deviate substantially from the target, leading the Fed to either inject or remove reserves from the system to nudge the rate closer to the target. (I explain this more fully here.)

In general the two are pretty close, i.e. the Fed is able to fine-tune the amount of outstanding reserves so that the market rate tracks the announced target rate, as the following chart makes clear. Note that blue is the target, while red is the “effective” federal funds rate (click for larger image). Also note that there is a few days’ lag in this data, and also it gives daily averages. So even if we waited a few days and looked back at this chart with the latest data, it wouldn’t show a huge spike in the red line up to 6 percent, since over the whole day today, the market rate won’t be at 6 percent (since the government just injected an additional $50 billion to knock it down).

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