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More Measures Introduced to Help Financial Markets

On October 8, the Federal Reserve joined with several other central banks to announce reductions in policy interest rates. The Fed's policy-making body, the Federal Open Market Committee (FOMC), voted to reduce the target for the federal funds rate to 1.5 percent. The Bank of Canada, the Bank of England, the European Central Bank, the Sveriges Riksbank, and the Swiss National Bank also reduced interest rates. The FOMC's statement for this intermeeting move noted that "incoming economic data suggest that the pace of economic activity has slowed markedly in recent months. Moreover, the intensification of financial market turmoil is likely to exert additional restraint on spending, partly by further reducing the ability of households and businesses to obtain credit."

At its next meeting on October 28 and 29, the FOMC unanimously decided to again reduce the target for the federal funds rate by 50 basis points, bringing it to 1 percent. In its statement, the FOMC stated that "recent policy actions, including today's rate reduction, coordinated interest rate cuts by central banks, extraordinary liquidity measures, and official steps to strengthen financial systems, should help over time to improve credit conditions and promote a return to moderate economic growth."

Reserve Market Rates

On October 6, the Federal Reserve announced that it will pay interest on depository institutions' required and excess reserves. This change had been planned and was scheduled to go into effect in 2011, but the Emergency Economic Stabilization Act of 2008 accelerated the effective date to October 1, 2008. The rate paid on required reserves was set to the federal funds rate target minus 10 basis points. The Federal Reserve statement explains that "paying interest on required reserve balances should essentially eliminate the opportunity cost of holding required reserves, promoting efficiency in the banking sector." The rate on balances in excess of those required was set to the federal funds rate target minus 75 basis points.

An advantage to paying interest on excess reserves is that it is expected to make it easier for the Federal Reserve to keep the effective federal funds rate close to the target rate. During times of financial stress, the effective funds rate has fallen below the target funds rate. The idea behind the new approach is that if banks can earn interest on excess reserves, the funds rate should always remain above the rate paid on those reserves. Presumably, whenever the effective federal funds rate falls below the interest rate that banks can earn on excess reserves, they would have an incentive to borrow at the funds rate and park the cash in reserves. This "arbitrage" opportunity would put upward pressure on the funds rate until the effective funds rate was at least as great as the interest rate earned on excess reserves.

Federal Funds Rate and Interest on Reserves

For reasons not well understood, even after interest began to be paid on reserves, the effective funds rate still traded below the rate on excess reserves. Nevertheless, on October 22, the Federal Reserve announced an alteration to the formula for interest paid on excess reserves. Instead of subtracting 75 basis points from the target of the federal funds rate, the new formula subtracts only 35 basis points. The Board explained this decision, stating that "a narrower spread between the target funds rate and the rate on excess balances at this time would help foster trading in the funds market at rates closer to the target rate."

The Board continued to have trouble meeting its funds rate target and announced on November 5 another change. "Under the new formulas, the rate on required reserve balances will be set equal to the average target federal funds rate over the reserve maintenance period. The rate on excess balances will be set equal to the lowest FOMC target rate in effect during the reserve maintenance period. These changes will become effective for the maintenance periods beginning Thursday, November 6. The Board judged that these changes would help foster trading in the funds market at rates closer to the FOMC's target federal funds rate."

The Federal Reserve has continued to take measures to provide additional liquidity to the credit markets. Following major financial market stress in September, liquidity became extremely strained. The spread between the one-month Libor and the one-month OIS jumped from around 50 basis points on September 12 to 338 basis points on October 10. (Libor is the London interbank offer rate, the interest rate at which banks lend money to each other in London, and the OIS is the overnight index swap rate.) The three-month Libor-OIS spread showed similar results, reaching its peak of 3.64 percent on October 10. These liquidity spreads have improved somewhat since then, but still remain at near-record levels. Currently, the spread between the one-month Libor and the one-month OIS stands at 174 basis points.

Libor-OIS Spread

Perhaps more alarming was that, along with these liquidity issues, there were signs of stress in the short-term commercial paper market. Firms borrow in this market to meet current operating expenses; loans are short-term and unsecured. The Federal Reserve addressed the stress in this market by creating the Commercial Paper Funding Facility and the Money Market Investor Funding Facility. The spread in the financial commercial paper market had been on the rise in September.

Commercial Paper Spread

Under the Commercial Paper Funding Facility, the Federal Reserve Bank of New York finances the purchase of unsecured and asset-backed commercial paper from eligible issuers through its primary dealers. The interest rate charged is the three-month OIS rate plus 100 basis points. Since the normal spread is less than 50 basis points, it is hoped that this new intervention will naturally dissipate as markets improve. This facility appears to have been successful in that after its introduction, the value of commercial paper outstanding jumped. The jump is particularly notable in financial commercial paper, which had been hit especially hard by the credit squeeze.

Commercial Paper Value
Financial Commercial Paper Value

The next FOMC meeting is scheduled for December 16. The markets are almost even on expectations between no change in the federal funds rate at that meeting and a 50 basis point cut to 0.50 percent. Implied yields on federal funds futures suggest that the fed funds rate will reach its minimum toward the end of this year, and then begin a gradual climb during 2009. Given the zero-bound restriction on interest rates, most analysts do not see the Fed cutting rates more than another 50-75 basis points. After that point and if it becomes necessary, the Fed must use another instrument to stimulate the economy. The perception is that the Federal Reserve will practice quantitative easing. This is the monetary strategy followed by the Bank of Japan when it cut rates to near-zero and then flooded the market with liquidity to stimulate private lending.

December Meeting Outcomes
Implied Yields on Federal Funds Futures

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