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

By: Paul Kasriel | Mon, Dec 8, 2008
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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 Kasriel

Author: Paul Kasriel

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

Paul Kasriel

Paul joined the economic research unit of The Northern Trust Company in 1986 as Vice President and Economist, being named Senior Vice President and Director of Economic Research in 2000. His economic and interest rate forecasts are used both internally and by clients. The accuracy of the Economic Research Department's forecasts has consistently been highly-ranked in the Blue Chip survey of about 50 forecasters over the years. To that point, Paul received the prestigious 2006 Lawrence R. Klein Award for having the most accurate economic forecast among the Blue Chip survey participants for the years 2002 through 2005. The accuracy of Paul's 2008 economic forecast was ranked in the top five of The Wall Street Journal survey panel of economists. In January 2009, The Wall Street Journal and Forbes cited Paul as one of the few who identified early on the formation of the housing bubble and foresaw the economic and financial market havoc that would ensue after the bubble inevitably burst. Through written commentaries containing his straightforward and often nonconsensus analysis of economic and financial market issues, Paul has developed a loyal following in the financial community. The Northern's economic website was listed as one of the top ten most interesting by The Wall Street Journal. Paul is the co-author of a book entitled Seven Indicators That Move Markets.

Paul began his career as a research economist at the Federal Reserve Bank of Chicago. He has taught courses in finance at the DePaul University Kellstadt Graduate School of Business and at the Northwestern University Kellogg Graduate School of Management. Paul serves on the Economic Advisory Committee of the American Bankers Association.

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