After eight years of unprecedented intervention in financial markets, the Federal Reserve has taken the first baby steps in a long-term mission to extract itself. But it's good to have a backup plan just in case that doesn't work out.
That's one way to look at the new "overnight bank funding rate" the New York Fed unveiled Wednesday. The rate is intended to shore up the calculation that comprises the federal funds rate, a once-robust gauge of interbank borrowing costs that serves as the U.S. central bank's monetary policy target, but has lost its significance as a barometer of underlying economic activity since the 2008 financial crisis.
The Fed's cash injections into the financial system—through bond purchases that have added around US$2.4 trillion to bank balance sheets—and a spate of new regulations have combined to reduce interbank lending by 88 percent from its peak of $482 billion in September 2008, right before the crisis struck. As a result, less than 10 percent of transactions in what is left of the fed funds market are banks borrowing from one another to meet reserve requirements, according to the New York Fed.
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At the same time, in the wake of international rate-rigging scandals, global regulators are pushing to strengthen benchmark interest rates that are used widely to value trades in multitrillion-dollar derivatives markets, partly by broadening the base of actual transactions that go into the calculation of the rates. While the diminished fed funds rate may no longer meet the standard of a regulator's ideal benchmark, the new overnight bank funding rate might fit the bill.
"What the Fed is probably doing with the overnight bank funding rate is trying to, in essence, hedge for a future where the fed funds market never really does return to being a viable market again," said Ward McCarthy, chief financial economist at Jefferies LLC in New York.
That could happen if policy makers opt not to wind down the central bank's $4.5 trillion balance sheet, or if they don't get the chance. The Fed has said it will begin shrinking the balance sheet when interest-rate increases are "well under way," though a New York Fed survey shows dealers don't expect this to happen for at least a year.
Federal Funds and Eurodollar Transactions
Until they reduce the balance sheet to a more normal level, the behavior of the fed funds rate is largely in the hands of U.S. federal home loan banks, which now account for more than 90 percent of lending in the post-crisis fed funds market. Their activity is dominated by lending to U.S. branches of foreign banks, which engage in a trading strategy of borrowing the cash and depositing it in accounts at the Fed overnight, earning the interest the Fed pays on reserves held at the central bank.
The home loan banks also have accounts at the Fed, allowing them access to the fed funds market. But because the Fed can't legally pay them interest, they are forced to lend their excess cash into the market at rates below what the Fed pays.
To make the measure of market rates more robust, the new overnight bank funding rate will draw upon the $70 billion of daily transactions in fed funds, but will add a further $250 billion of eurodollar transactions to the mix. Both are calculated as a daily average of recorded trades.
The eurodollar market is so similar to fed funds that the fed funds rate and the new overnight bank funding rate have historically been nearly identical. The New York Fed said Wednesday that the overnight bank funding rate was 0.37 percent on March 1, based on $324 billion of transactions in fed funds and eurodollars. The effective fed funds rate was 0.36 percent, based on $76 billion of transactions in fed funds.
That could change if the fed funds market continues to shrink.
"These new rates are a very important and positive development. The Fed is strengthening these rates through greater traded volume in the calculation," said Tom Wipf, a managing director at Morgan Stanley in New York who is a member of the Alternative Reference Rates Committee, a Fed-sponsored group of market participants at the forefront of work on benchmark reform. "To the extent that we see changes in either one of those markets, the market is not overly reliant on a specific set of activities."
One such scenario is negative rates, which have been adopted by central banks in Europe and Japan to spur growth and drive inflation higher. Chair Janet Yellen said last month the Fed is looking at them as a potential tool in a future crisis.
Negative Interest Rates Might Kill Fed Funds Market
If the Fed were to implement negative rates, home loan banks might just leave cash in accounts at the Fed and earn zero interest, killing what little activity remains in the fed funds market. In the eurodollar market, on the other hand, non-bank financial institutions without access to accounts at the Fed—mostly money-market mutual funds—are the ones doing the lending. Without access to Fed accounts, those funds are more likely to be forced to continue lending, even at negative rates.
"There are lots of paths the money markets and the Fed together could go down, and there are enough where it would be very nice to have a spare reference rate on the shelf that this is a very worthwhile endeavor," said Lou Crandall, chief economist at Wrightson ICAP LLC in Jersey City, New Jersey. "As to whether or not fed funds do ever come unhinged, that's hard to say. It's not impossible, but it's certainly not inevitable."
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