macroblog

A funny thing happened on the way to the federal funds market

Since the beginning of this year, the effective funds rate in the market for reserve balances has varied between zero and about 15 basis points below the interest rate the Federal Reserve pays on those reserve balances (see chart below, which runs through July 2). A vexing issue has been the fact that the interest paid on reserve balances at the Fed has not set a floor on the funds rate traded in the funds market, but rather it has acted more like a magnet (see, for example, this PrefBlog post from early this year).

On July 2, the Federal Reserve Board’s latest amendments to Regulation D (Reserve Requirement of Depository Institutions) went into effect. Included in these changes are two that could materially affect the fed funds market and that vexing gap between the fed funds market rate and the deposit rate.

The first is the authorization for correspondent banks to create Excess Balance Account (EBA) programs on behalf of their respondent financial institution clients. The second is the nullification of an exemption that allowed ineligible institutions (such as the Federal Home Loan Banks) to earn interest on their reserve balances as a result of providing reserve management services for banks.

This change is good news for the 20 or so bankers' banks that provide respondent banks, usually community banks, with services, such as managing the respondent’s reserve balances at the Fed. Prior to the change in Regulation D, a bankers' bank was required to pool all the respondent’s reserve deposits into its own reserve account. This task is a bit of a problem when excess reserves are at high levels because reserves are a bank asset that counts against regulatory capital-to-asset ratios. Partly because of this financial leverage concern, bankers’ banks have had to sell some of their respondent excess reserves into the fed funds market and earn less than the 25 basis points offered for reserve balances at the Fed. But with the change in Reg. D, they will be able to deposit respondent balances at the Fed in the EBAs, and this approach will alleviate their balance sheet pressure.

What does this change mean for the funds market? Well, one source of supply of funds will be reduced, and that should put upward pressure on the fed funds rate. That’s good news for closing the deposit/market rate spread, although it should be said that bankers’ banks represent only a small fraction (about 5 percent) of daily fed funds market activity, so the impact will probably be equally small.

The second change could be a more significant one and will tend to put downward pressure on the effective funds rate. Nine of the 12 Federal Home Loan Banks (FHLBs) provide respondent banking services (like bankers’ banks) for some of their member institutions. These FHLBs had been pooling their own reserve balances with their respondents’ balances, thus earning interest on their own reserves as well. Technically, the FHLBs, like other government-sponsored enterprises, are ineligible to earn interest on their own reserve balances held at the Fed, but the FHLBs were given an exemption under the interim rule published last year, which did not distinguish between an FHLB’s own reserve balances and those of their respondents. With the amended Reg. D, the pooling of reserves will no longer be allowed. Thus, the FHLBs will not be able to earn interest on their own reserve balances.

Will this change matter to them? A look at the FHLB consolidated balance sheet suggests it could. For instance, as of Sept. 30, 2008, the FHLBs were sellers of some $94 billion of fed funds and held zero on deposit at the Fed. But as of Dec. 31, 2008, after the Fed started paying interest on reserves, the FHLBs sold only $40 billion of fed funds and held $47 billion on deposit at the Fed. In a funds market that has been experiencing relatively light volumes in 2009 year to date, the potential additional supply of dollar reserves by the FHLBs could materially affect rates in the fed funds market.

What happened when the regulation changes took effect yesterday? Well, the fed funds effective rate yesterday declined from 20 to 17 basis points. Thus, it appears the softer funding conditions expected as a result of the changes generally failed to materialize. But it still may be too early to determine the full impact of the regulation changes, and more definitive changes in trading could materialize in coming days. Fed funds market nerds stay tuned.

By John Robertson, vice president in research at the Atlanta Fed

Private sector forecasts at variance

Economic forecasts are notoriously inaccurate. That isn't a statement about the ability of forecasters, but rather a statement about the complexity of the economy. If you're looking for a humbling experience, I recommend you give it a try.

And today's economy would seem to be an exceptionally difficult environment in which to forecast. As economists peer into the future, there seems to be an unusually wide range of opinion about what to expect. Uncertainty is running pretty high right now in the minds of the top prognosticators.

Consider the following predictions from the Blue Chip panel of economists concerning the economy's growth rate a year and a half from now (fourth quarter 2010). The average growth rate expected in that time frame from the panel is 3 percent, which isn't that different from the six-quarter-ahead forecast they have made every June during the past 10 years or so. But if you compare the difference between the economic optimists (the 10 highest growth forecasts) relative to the economic pessimists (the 10 lowest growth forecasts), the discrepancy between the two views is large relative to recent history. In short, the forecasts on the optimistic end of the spectrum are now more optimistic while the pessimistic forecasts are a little more pessimistic.

Uncertainty over the medium-term outlook is particularly large regarding the experts' views on inflation. In the latest survey of the Blue Chip panel, the difference between the 10 highest and the 10 lowest inflation predictions for the fourth quarter of 2010 was a gaping 3.7 percentage points (compared with an average of about 1.5 percentage points over the past decade and a half). This wide range of opinions about inflation prospects started to emerge last year as economic conditions deteriorated.

Disharmony in the panel's inflation outlook doesn't so much suggest that those expecting inflation now see greater inflationary risks—at 3.2 percent the medium-term inflation prediction of the highest 10 inflation forecasts isn't materially different from where it has been since the late 1990s. Instead, the larger variance in the inflation outlook is coming from those at the bottom of the panel's forecast distribution that are anticipating even more downward price pressure than in previous years.

Pinpointing the future trajectory of the economy is generally considered more difficult near turning points in the business cycle—though the current uncertainty would appear to be particularly large, recession or not. Such uncertainty about the future is surely adding to the challenges facing the business community as it strives to get back on its feet.

By Laurel Graefe, economic research analyst at the Federal Reserve Bank of Atlanta

CPI: The left and the right of it

Updated 11:30 a.m.

We got a good reading of May's inflation numbers this week. On both the producer and the consumer sides, price measures for the month came in well short of market expectations. The prospect of deflation has been getting a good deal of coverage in the blogosphere; see Andy Harless' blog, Economist's View, and Paul Krugman's column.

Greg Mankiw, however, points out that a trimmed mean estimate of the consumer price index (CPI), which removes the large relative price changes in each month, makes the deflation story seem a bit, uh, exaggerated.

"As every grade school student learns when the teacher reports results of the latest test, the average of any data set can be thrown off by a few extreme outliers; the median is a more robust statistic to estimate the central tendency in the data.

"Right now, the two measures of inflation are diverging substantially. The standard CPI shows deflation over the past year, but that average is due to a few anomalous sectors, such as energy. If you look at the median CPI, which shows what a more typical price is doing, the inflation rate does not look very unusual."

While the median is certainly a valuable way to look at inflation, there is also some interesting information that can be gleaned from breaking down the whole distribution of prices.

The chart below (hat tip to Brent Meyer at the Cleveland Fed) shows another interesting feature of yesterday's CPI release. Notice the clear downward shift in the distribution of CPI component price changes. Over half of the prices within the CPI market basket posted growth at or below 1 percent last month, up from an average of 29 percent in 2008, with a whopping one-third of the price index posting declines in May.

Of course, one month does not a trend make, but the month's price numbers were nonetheless noteworthy.

By Laurel Graefe, economic research analyst at the Atlanta Fed

Price stability and the monetary base

Arthur Laffer, as several readers (and friends) have pointed out to me, is taking aim at the Fed:

"… as bad as the fiscal picture is, panic-driven monetary policies portend to have even more dire consequences. We can expect rapidly rising prices and much, much higher interest rates over the next four or five years, and a concomitant deleterious impact on output and employment not unlike the late 1970s.

"About eight months ago, starting in early September 2008, the Bernanke Fed did an abrupt about-face and radically increased the monetary base—which is comprised of currency in circulation, member bank reserves held at the Fed, and vault cash—by a little less than $1 trillion. The Fed controls the monetary base 100% and does so by purchasing and selling assets in the open market. By such a radical move, the Fed signaled a 180-degree shift in its focus from an anti-inflation position to an anti-deflation position."

I have a few problems with that statement. To begin with, the notion that the Federal Reserve signaled a 180-degree shift in focus to move "from an anti-inflation position to an anti-deflation position" is about equivalent to saying that the temperature control system in your house has a fundamentally different objective when the heater kicks off in June and the air conditioning kicks on. The essence of an inflation objective—even an implicit one—is that a central bank will lean against price-level changes substantially below the desired rate, as well as changes substantially above the desired rate. You can certainly argue with the policymakers' forecasts and diagnoses of risks at any given time, but it serves the debate well to not muddle tactics (focusing on inflation or deflation as the economic weather requires) and objectives (the control of the inflation rate that is Mr. Laffer's true concern).

But that point is a quibble. The increase in the U.S. monetary base has indeed been something to behold, and the Laffer article gives a good explanation about why you might be worried about that:

"Bank reserves are crucially important because they are the foundation upon which banks are able to expand their liabilities and thereby increase the quantity of money.

"Banks are required to hold a certain fraction of their liabilities—demand deposits and other checkable deposits—in reserves held at the Fed or in vault cash. Prior to the huge increase in bank reserves, banks had been constrained from expanding loans by their reserve positions. They weren't able to inject liquidity into the economy, which had been so desperately needed in response to the liquidity crisis that began in 2007 and continued into 2008. But since last September, all of that has changed. Banks now have huge amounts of excess reserves, enabling them to make lots of net new loans…

"At present, banks are doing just what we would expect them to do. They are making new loans and increasing overall bank liabilities (i.e., money). The 12-month growth rate of M1 is now in the 15% range, and close to its highest level in the past half century."

OK, but in my opinion it is a bit of a stretch—so far, at least—to correlate monetary base growth with bank loan growth:

Let's call that more than a bit of a stretch.

The Laffer argument is in large part about what the future will bring. But we know that the payment of interest on bank reserves—which we have discussed in this forum many times (here and here, for example)—means a higher demand for reserves in the future than in the past. This change, of course, means that levels of the monetary base that would have seemed scary in the past will become the new normal. How big can the "new normal" be? That's a good question, and one I will continue to contemplate. But the assertion in the Laffer article that "a major contraction in monetary base" is required cannot be supported by either current evidence or simple economic theory.

There is, however, more. Whatever policy choices are required to deliver a noninflationary environment going forward, Mr. Laffer seems convinced that the central bank is not up to making them:

"Alas, I doubt very much that the Fed will do what is necessary to guard against future inflation and higher interest rates. If the Fed were to reduce the monetary base by $1 trillion, it would need to sell a net $1 trillion in bonds. This would put the Fed in direct competition with Treasury's planned issuance of about $2 trillion worth of bonds over the coming 12 months. Failed auctions would become the norm and bond prices would tumble, reflecting a massive oversupply of government bonds."

On this I will just turn to my boss, Atlanta Fed President Dennis Lockhart, who addressed this very issue in a speech given today at the National Association of Securities Professionals Annual Pension and Financial Services Conference in Atlanta:

"The concerns about our economic path are crystallized in doubts expressed in some quarters about the Federal Reserve's ability to fulfill its obligation to deliver low and stable inflation in the face of very large current and prospective federal deficits. In a word, the concerns are about monetization of the resulting federal debt.

"I do not dismiss these concerns out of hand. I also recognize that the task of pursuing the Fed's dual mandate of price stability and sustainable growth will be greatly complicated should deliberate and timely action to address our fiscal imbalances fail to materialize. But I have full confidence in the Federal Reserve's ability and resolve to meet its inflation objectives in whatever environment presents itself. Of the many risks the U.S. and global economies still confront, I firmly believe the Fed losing sight of its inflation objectives is not among them."

'Nuff said, for now.

By David Altig, senior vice president and research director, at the Atlanta Fed