Myths About Fed Funds & Liquidity
With the Federal Reserve’s FOMC meeting this week, and with Fed funds futures traders pricing in the probability of a ¼ point cut, various pundits and commentators are all in agreement that the Fed will be done cutting the overnight rate for some time to come. Both supply-siders and Keynesian economists will undoubtedly cheer the move as being a big victory for the Fed in the fight against inflation. These cheers will be based on an erroneous conception of inflation as a momentary phenomenon, easily started and stopped. In reality, inflation is a gradual process, as key indicators like gold, oil, and commodities have been telling us over the last several years while the Fed Funds Rate has been fluctuating between 5.25% and its current 2.25%.
Leaving aside the highly dubious proposition that the difference between a 2% or sub – 2% fed funds rate is inflationary, deflationary, or just right, the circumstances present an opportunity to really examine the premise that the fed funds rate is the ‘liquidity valve’ that many say it is. To do so, one must understand just what ‘liquidity’ is and how is it measured. Liquidity in its basic form is base reserves, which are added and subtracted from the banking system via open market operations in New York. It is through this process that the Fed creates monetary expansion or contraction. Liquidity can also be added by tweaking the reserve requirements, or through direct lending through the discount window. But direct lending and adjustment of the reserve requirements have historically been a small part of the Federal Reserve’s operations compared to base reserve adjustment via buying and selling of U.S. Treasuries.
It is important to note that many tend to look to the money supply measures as liquidity indicators of an inflationary or deflationary monetary policy. This is misleading. Money supply measures are all derivatives of the same starting point - base reserves. The Fed can’t control how reserves are utilized, nor can it directly control what proportion of reserves goes to loans, investments, or cash.
The fed funds rate, on the other hand, is the overnight rate that is charged by banks for lending their excess reserves held at the Fed to each other. The common perception is that the Fed utilizes open market operations to influence the amount of reserves in the system and therefore drive the Fed Funds rate to its target rate, set by the FOMC.
Upon closer inspection of the Board of Governor’s own data, however, this theory is indeterminate at best. In fact, the fed funds rate is not strongly correlated with reserves at all. From the late 50s through the early 80s, the fed funds rate went through several cyclical patterns, generally peaking at the top end during the early days of Volcker’s term as Federal Reserve Chairmen. During this time, base money reserves grew at a steady 3.1% annual rate regardless of the Fed funds rate (remember Milton Friedman’s 3% rule?). During this same period, the fed funds rate see-sawed from as low as 1% to as high as 19%. Subsequently, through a few start-and-stop cycles under Alan Greenspan and Ben Bernanke, the fed funds rate has generally trended downward, while net reserves are essentially where they were in 1991 with a single deflationary period and a single inflationary period in the interim.
Furthermore, two very specific temporary injections of reserves, once after 9-11 and once last August, had a de minimus effect on the effective fed funds rates. After 9-11, a 45% increase in reserves amounted to a 16% decrease in the fed funds rate in the month of September. This is not a significant amount considering the fed funds rate continued to decline while reserves quickly recovered to previous levels. Similarly, in August 2007, in response to the freezing of credit markets, the Fed added $39 billion with zero effect on the Fed Funds rate.
Because every now and then the Fed tries to engineer economic growth through liquidity expansion regardless of fiscal and regulatory policy, it is illuminating to observe in hindsight that the Fed has actually enabled three inflationary periods (1970s, 1990 – 1991, and 2002 +) and two deflationary periods (1980 – 1982 and 1997 – 2001). Each of these periods has had markedly different levels of fed funds rates. One can also infer from the data that fed funds rate varies widely between different periods of monetary instability, the prevention of which is presumably one of the primary objectives of the Fed’s manipulation of the fed funds rate. If one is still certain that the fed funds rate is the Fed’s liquidity tool, then perhaps a review of the St. Louis Fed’s November 2007 study is required, in which the Fed acknowledges statistically what can be understood by simply looking at the raw data.
A closer look at the relationship between the Fed Funds rate and base reserves would be helpful to the ongoing discussion about the Fed’s current policy actions. If we could get past the debate about the use of the Fed Fund’s rate as a policy tool, we could begin discussing the more important issue of the Fed’s failure to adhere to its real purpose: the maintenance of a stable dollar regardless of the level of liquidity as measured by reserves.