Recent Firming in the Federal Funds Market
Starting at the end of February 2010, the effective federal funds rate has seen a persistent firming in daily average rates, where firming refers to a higher rate, closer to the floor established by the interest rate on reserves. This rise in the funds rate began following the announcement by the Treasury to revive its Supplemental Financing Program (SFP) on February 23. Specifically, the Treasury announced that it would issue $200 billion in SFP debt and deposit the funds in its account at the Fed. This action removes reserves from the banking system and could put upward pressure on the federal funds rate. The SFP-related reserve draining is illustrative of the kind of effect the Federal Reserve expects from the implementation of its own newly designed reserve-draining tools.
While it is tempting to attribute the firming in observed rates to the revival of the SFP, it may not be possible to separate the effects of the SFP from other events that have occurred recently. For example, the discount rate increased from 50 basis points to 75 basis points on February 18, after which markets may have altered their assumptions about the future path of the federal funds rate and started to trade funds at a higher rate.
Another factor adding to upward pressure on the federal funds rate was an increase in new Treasury debt issues around the April tax deadline. Because the new issues become collateral for borrowers of funds, they can generate so-called collateral effects. As firms vie for the funds in secured money markets (repo markets, for example), an abundance of longer-term collateral can be used to obtain overnight funds. The issuance of a larger amount of attractive collateral by the Treasury thus often pushes up rates in secured money markets, as Treasury security holders bid the rates up. These rates put pressure on unsecured (federal funds) markets, which are close substitutes for repos.
Since the first settlement of the revived SFP auctions on February 25, the funds rate has increased steadily and persisted above levels that had not been reached since before September 2009, when the Treasury decided to reduce its SFP balance. Firm conclusions are hard to draw from this observation, though, because reserve balances have declined as well and the flow effects of subsequent auction settlements have been inconsistent in their influence on the funds rate.
Beginning on February 24, the balance of excess reserves in the system has been in constant decline, and thus funds available in the federal funds market have been scarcer. However, not all declines in reserves have corresponded to a rise in the federal funds rate, suggesting that the flows of funds are being counteracted by other market forces. On March 4, government-sponsored enterprises (GSE) began tightening their credit lines, effectively offering less cash in the funds market, which should have had a persistent firming effect on the funds rate. This firming, however, is dependent on the demand for funds, which may be distorted by calendar effects (like ends of quarters and tax day) and collateral availability. These types of distortions were evident on March 16, when Freddie Mac completed a delinquent loan buyout and removed some of its lendable federal funds. In an action that should have firmed the market, rates dropped 2 basis points, part of a continual tumble toward the end of the first quarter.
The one sharp deviation in the upward rise in the federal funds rate occurred at the end of the first quarter, when the effective funds rate dropped to 0.09 percent. Such quarter-end deviations often occur as firms try to clean up their balance sheets.
What should be learned from these observations is not that reserve draining may be futile and unpredictable, but that the market for federal funds is complex. Movements and trends in the prevailing rate often cannot be attributed to a single event, and constant monitoring of the supply and demand for federal funds will be essential in maximizing the potential of the reserve draining tools available to the Federal Reserve.