Market Debates Why Fed Funds Rate Is Often Below Targets

Market watchers are wondering why the federal funds rate has often fallen significantly below target on key settlement dates this year.

At the end of nine settlement periods this year, the closing rate on fed funds -- the rate banks charge each other for reserves -- has been below the target set by the Fed by more than 2 percentage points.

By comparison, the closing rate exceeded the target by 2 points only three times on settlement dates, when banks must ensure they have had enough funds on average in their reserve accounts over the previous two weeks to meet regulations.

Settlement Date a Factor

A spokesman for the Fed says there is no mystery: Deviations from the target rate are merely coincidental.

"It's almost impossible to hit the target exactly because there's so much going on in the market," he says, "but there's no deliberate policy" about whether the rate ought to close above or below the target rate.

Yet some observers think the dips in the fed funds rate do reflect conscious Fed policy decisions, ranging from simply wanting to keep rates low to a desire to make it easier for banks to avoid the discount window.

One possibility: The central bank is erring on the side of adding too much to reserves because it wants to make sure the market rate stays low.

Excessive Liquidity?

"If your monetary policy is geared toward easing and you want to provide enough liquidity to the banks, there may be a slight tendency to overprovide reserves," said Henry Engler, a money market economist at Chemical Banking Corp.

"You don't want banks to be forced to pay high rates for funds at a time when you're trying to encourage lower borrowing costs."

"I think the Fed's being generous because they're trying to get the economy going again," agreed Ivan Marcotte, an economist at NCNB Corp. "If the Fed's adding reserves, that gives banks money to put into loans or securities."

Another reason why the market may be awash in reserves is that banks are consolidating. Fewer loans mean less deposits and lower reserve requirements.

Need Questioned

"When they don't make loans, they don't need reserves," said a fed funds broker. "Banks are not making loans, so they don't need money." He said U.S. banks are much less active in the broker market for fed funds now.

The third possibility is more Machiavellian: Some think the Fed may be keeping rates low on settlement dates to enable banks to avoid its discount window.

In more normal times, borrowing from the Fed during the chaotic close of a two-week settlement period was perfectly acceptable. Indeed, the discount window has traditionally been a funding source of last resort when last-minute market dislocations push the Fed funds rate to stratospheric levels and banks still need reserves.

Borrowing from the Fed these days for any reason, however, runs the risk of becoming a public relations disaster.

"Even though the Fed keeps saying the window is supposed to be a pressure valve, you have some Congressman coming out and saying X borrowed, so there must be a problem," said a fed funds trader at a regional bank. As a result, "I think the Fed goes out of its way to make sure there are enough reserves."

If the market gets wind of a bank's trip to the discount window, that bank can soon be hard pressed to borrow from others because its creditworthiness could be questioned.

The problem is especially acute for big New York banks. Their reserve needs often change dramatically late in the day, so there is always a chance they will have a last-minute need for more reserves than the market can supply.

Moreover, money-center banks tend to rely relatively heavily on purchased funds, so they would suffer more if other banks grew wary of trading with them, and their sheer size means the bank capital markets would be unsettled as a result.

Consequently, they have a strong interest in staying away from the discount window, and experts say the Fed may be trying to help them do so.

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