Printer Friendly

eMail Article

December 08, 2008

If the Fed Wants to Stimulate Bank Lending, Keep Its Target at 1.00%
by Paul Kasriel

After the release of the weak November employment data, the market more than ever expects the FOMC to reduce its federal funds rate target from the current 1.00%. But if the Fed really wants to stimulate bank credit extension to the private sector, it will leave its funds rate target level at 1.00% but keep flooding the market reserves so that the effective funds rate continues to trade below the target rate. As the chart below shows, since early in October, the effective federal funds rate has consistently traded below the FOMC target rate.

Chart 1

Why would a drop in the FOMC's target rate be a negative for bank lending? The banking system needs to earn higher profits to help recapitalize itself. The Fed now pays interest to depository institutions on both their required and excess reserves. The rate of interest paid on excess reserves is the lowest FOMC target rate during a reserve maintenance period. Non-depository institutions, such as the Federal Home Loan Banks, are not eligible to earn interest on their holdings of federal funds. When the Fed floods the financial system with reserves and these non-depository institutions end up with more federal funds than they need, they sell them in the market for whatever they can fetch. Banks that are able to purchase these federal funds at below-target rates can hold them as excess reserves, earning the spread with very little interest-rate risk. So, if the FOMC were to reduce its federal funds rate target, it would reduce the arbitrage profit spread depository institutions are currently earning, which would slow down the bank recapitalization process.

You might ask why the FOMC does not raise its fed funds target. After all, this would increase the arbitrage profits earned by depository institutions, thereby speeding the recapitalization process. The only problem with this is that the interest rates charged to banks' private-sector loan customers might be marked up, thus reducing the quantity of bank loans demanded. So, the Fed staffers might have to do some econometric work to see what target funds rate would maximize bank lending, balancing the recapitalization process, which argues for a higher target rate, with the loan demand, which argues for a lower target rate.

Paul L. Kasriel, Director of Economic Research
The Northern Trust Company
Economic Research Department
Positive Economic Commentary
"The economics of what is, rather than what you might like it to be."
50 South LaSalle Street, Chicago, Illinois 60675

The information herein is based on sources which The Northern Trust Company believes to be reliable, but we cannot warrant its accuracy or completeness. Such information is subject to change and is not intended to influence your investment decisions.

Copyright © 2005-2009 The Northern Trust Company

Image rendition and html coding Copyright © 2000-2009 SafeHaven.com

« Opinions expressed at SafeHaven are those of the individual authors and do not necessarily represent the opinion of SafeHaven or its management. Articles are available via RSS/XML. Please visit RSSHelp for instructions. »