The Federal Reserve is caught with a structural problem in the way it attempts to transmit monetary policy to the economy that makes raising rates problematic.
This column will be an extension of the issues I discussed in the column, "Where Banks Get Their Money," in which I introduced the concepts of "Fed funds sold" and "Fed funds purchased."
In this column I'll introduce the concept of the "Fed funds effective rate" (FFER), how it is calculated, how it affects the banking system, and why it presents the Fed with a big problem in attempting to raise the Fed funds target rate.
First, on the subject of Fed funds sold and purchased, there have been some changes in the composition over the past few years.
On the purchased side, there's been a substantial reduction for all four of the money centers. JPMorgan Chase (JPM) and Bank of America (BAC) have reduced their carried Fed funds purchased by about 50% to about $94 billion and $34 billion, respectively.
Wells Fargo (WFC) and Citigroup (C) have also reduced their carried Fed funds purchased by about 25%, to $19 billion and $15 billion, respectively.
For the purposes of this column, I will just state that this is a positive sign of the ongoing balance sheet repair at the money centers.
On the Fed funds sold side, the issue is a bit murkier. The carried sold Fed funds, money that has been loaned by the money centers to the rest of the banking system for meeting overnight reserve requirements, has changed little at Wells, Bank of America and Citi.
An issue arises with JPMorgan, though, in that although it has reduced its sold Fed funds from $280 billion to $174 billion, it is still providing a substantial amount of capital to the rest of the banking system.
This is also the point at which understanding the transmission mechanism for Fed rate hikes, and how they are reflected in the real banking system, is important.
As bizarre as it may sound, the Fed does not know and actively does not track the real rate at which banks are lending to each other for reserve purposes.
Although the current Fed funds target rate is 0-0.25%, the FFER is about 0.12%.
The FFER is an estimate of what the Fed believes to be the average weighted cost of borrowing for all banks, as voluntarily reported by member banks and fed funds brokers.
Further, and this is critically important, is that the actual rate charged by lending banks and paid by borrowing banks is very wide, with a spread of between roughly 0.05% and 0.5%.
In general, the largest banks pay the least, and as the size of the borrowing institution falls, the rate paid by it for overnight reserves increases.
The result is that although we refer to the current Fed funds target rate of 0-0.25% as zero interest rate policy (ZIRP), and the FFER is about 0.12%, the actual rate paid for overnight reserves is substantially higher for most of the approximately 6,500 banks in the U.S.; closer to 0.3% on average already, and only lower at the largest money centers, at about 0.05% currently.
One of the reasons for the very wide spread is that the Fed is paying the largest money centers 0.25% on their excess reserves parked at the Fed. In order to get them to lend the money to other banks instead of to the Fed, the borrowing banks are forced to offer a higher rate of interest than the Fed is paying.
This puts JPMorgan in the position of being able to borrow Fed funds at 0.05% and lend it for more than 0.25% to the rest of the banking system, defeating the purpose of ZIRP in the process and arbitraging the benefits of it to itself.
This is also one of the reasons that bank loan rates have not come down as much as borrowers have been expecting over the past several years.
As the Fed prepares to raise rates, the actual rate being paid for reserves by all banks will be critically important for the Fed to know, rather than just estimate, as they try to determine if the transmission of policy is working as intended.
As a result, the Fed announced plans to alter the way it calculates the Fed funds rate and to add another rate to the system, the overnight bank funding rate, which will include the cost of euro-dollar transactions.
The bottom line for investors to understand is that we just don't know how the banking system will respond to even a small increase in the Fed funds target rate to a simple 0.25% from a band of 0-0.25%.
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