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Short-Term Interest Rate Markets

A series of events dating back to November 2010 has significantly affected the functioning of short-term funding markets and, in turn, interest rates. The effects of these events can be seen in the trends of not only the federal funds market, but also the repo, commercial paper, Libor, and Eurodollar markets. Collectively, these developments—some of them having nothing to do with monetary policy—have served to ease short-term financing terms. Eventually, when the Federal Reserve begins to raise the target for the federal funds rate, it will probably need to take account of the dynamics of these changes in short-term funding markets.

Historically, the federal funds rate has been the primary instrument of monetary policy. Daily federal funds rates since November 2010 fall loosely into a series of three trends, all of which can at least be partially explained by an event that has influenced market participants.

Figure 1. Federal Funds Rate

In November, the Fed announced the second round of large-scale asset purchases, which consisted of the Fed buying $600 billion in Treasury securities through the end of June 2011. From early November there was a steady decline in the federal funds rate from about 20 basis points to 17 basis points. The purchases increased the supply of reserves in the federal funds market, which pushed down the price, the federal funds rate. Put another way, the increased supply forced cash investors to compete in the market at lower interest rates.

Similarly, the decision by the Treasury in early February 2011 to wind down its Supplemental Financing Account balance inserted more reserves into the market for cash investors to place. Combined with the asset purchases, this move accelerated the decline in the federal funds rate. This acceleration was reflected in another 4 basis point decline, from 17 basis points to 13 basis points, over the following two months.

By far the most studied of the three events, however, has been the change in the FDIC assessment base for deposit insurance. Many observers have argued that this is the move that caused the dramatic drop in the federal funds rate at the beginning of April, and it has also been credited for holding the effective rate at a fairly constant level of 10 basis points.

With the new FDIC assessment policy, insured depository institutions will be charged an insurance premium not on their amount of deposits, but on the difference between their total assets and their equity. Broadly speaking, this equates to their liabilities, but there are some subtleties that we’re going to skip over. Due to the change in the assessment base, depository institutions are now forced to pay an extra fee for any financed assets, including funds that they might borrow in the federal funds market. Since many of the funds available in the federal funds market are provided by non-bank institutions, the current primary purpose of borrowing these funds is to earn the interest on reserves (IOR) available at the Fed. So, banks are making the difference in the two rates (fed funds and IOR) as a profit. The new assessment implicitly increases the cost of the federal funds by adding that assessment rate onto the fed funds rate. As a result, some banks have exited the market, reducing overall demand for the funds dramatically. The fall in demand has reduced the funds rate.

A trend similar to that seen in the federal funds market can also be seen in a variety of repo markets. Repo markets function as a secured form of the federal funds market. Many of the market participants are the same, with banks borrowing funds and cash-heavy investors providing the funds. Because the three events explained above also relate to the supply and demand of these funds, the effects of those events also translate into the repo markets.

The repo markets saw the largest decline of all short-term money markets, with the trend in the rates falling from an average level of roughly 16 basis points to 4 basis points, with considerable volatility around the trend. Starting in November, there was a very gradual rate decline as extra cash started to flood the market, and that decline picked up as the Treasury reduced its Supplemental Financing Account (SFP). A slight difference in these markets is the need for banks to provide collateral when they are borrowing, which also contributed to the volatility in the rates. The supply of collateral was reduced somewhat by the Fed’s asset purchases and the reduction in the SFP, so there was a slightly larger drop in demand for repo funds.

Cash investors seem to have moved into other short-term markets in search of high returns. The new supply in these markets is evident in the declines in the London interbank offered rate (Libor), Eurodollar, and commercial paper interest rates. The declines were similar for all of these markets, with rates trending down gradually between November 2010 and March 2011, and dropping more dramatically starting in early April 2011 when the FDIC assessment kicked in. Examining current rates, all but those for Eurodollar deposits are now below 15 basis points. The decline in interest rates for longer-term loans in these markets also suggests some effort by investors to reach for better returns. One-month repo and one-month Libor rates have seen 5 basis point declines over recent months.

A number of near-term developments may affect these markets. The Fed will soon be ending its asset purchases, which should stop the flow of new liquidity into the market and allow time for a fuller evaluation of the effects of the purchases. Also, the FDIC assessments that took effect at the beginning of April will not be collected until the end of June, so banks may make adjustments to their market participation based upon their realized FDIC fees. Finally, the resolution of the debt ceiling situation could also have an impact on the functioning of short-term markets.

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