Wednesday, December 23, 2015

What Fed Rate Hike?

You and I don't borrow federal funds.  Federal funds are cash reserves traded only between commercial banks.  So, does it really matter what the federal funds rate is?

The answer is: normally yes.  But, not now.

Normally, the rate of interest on federal funds is increased by reducing the amount of federal funds in the system so that banks have to scramble to meet their legal cash reserve requirements. That's not what happened ten days ago when the "Fed raised the target federal funds rate."  No, indeed.

There are $ 2.5 trillion in excess cash reserves sloshing around in the commercial banking system, thanks to QE1, QE2, and QE3.  No bank needs to borrow reserves from anyone.  So, the Fed now pays 50 basis points (1/2 of one percent) on commercial bank cash reserves.  Thus, no rational bank would loan its reserves to another bank for less than 50 basis points.  Voila.  The target funds rate is raise by this strategem.

The problem:  no other rates get raised, because there is no "tightness" in the credit markets induced in this artificial manner.  Other than non-market rates, like prime rates, all other rates are lower today than they were before the "Fed raised rates."

This is like me going into a closet and announcing that I am raising the rate that I will charge my children to borrow money from me.  How does this affect the rate my neighbor is going to pay on a car loan or a home mortgage?  Answer: it won't.

The Fed has made itself irrelevant.  That doesn't mean the financial media won't remain obsessed with fed watching as opposed to checking out supply and demand to figure out the future direction of interest rates.  The Fed no longer matters in the real world (except that they have $ 3 trillion in securities hanging over the market).

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