Fed Has Effectively Cut Funds Rate: Analysts

Source : The Business Times, September 10, 2007

They say unusually large spread between fed funds target and effective rates signals Fed's next move

(NEW YORK) Here's a secret: The Federal Reserve has already cut the fed funds rate.

Yes, the Fed's target rate is still the same 5.25 per cent it has been since June 2006, and the US central bank has only formally cut the less-used discount rate on loans it makes directly to banks.

But going back to Aug 9, when global central banks started flooding financial systems with cash to prevent a complete shutdown of credit markets, the actual rate at which US banks are providing each other overnight funds, the fed funds effective rate, has averaged just under 5 per cent, according to Federal Reserve data.

That's equivalent to the 25-basis-point reduction in the fed funds target rate that many investors expect US monetary policy-makers to announce at their next meeting on Sept 18.

'The Fed already eased,' said Jim Bianco, president of Bianco Research in Chicago, a member of the bond market camp that says a de facto rate cut happened a month ago and a formal announcement of one on the 18th would be little more than a rubber stamp.

'This is really hard for many market participants. They are so locked into the target rate that they cannot see the game has changed. The target rate is meaningless,' Mr Bianco (President of Bianco Research) said.

Mr Bianco's view is not universal, however. Others counter that the Fed's out-sized liquidity injections are strictly temporary measures to ease credit conditions and are not the equal of a formal policy change by the Federal Open Market Committee.

This group does agree, though, that rubber stamp or not, the unusually large spread between the fed funds target rate and the effective rate is a clear signal of the Fed's next move.

Typically the effective rate rarely sways beyond a few basis points on either side of the target rate. But through last Thursday, the 21-day moving average on the effective rate has been 4.99 per cent - a 26-basis point spread.

In fact, the last time such a significant deviation between the two occurred for a persistent period was after the Sept 11 attacks. The Fed kept the banking system flush with cash and followed through with two rate cuts by the first week of October, including a rare inter-meeting cut on Sept 17, 2001.

The effective fed funds rate - a weighted average of where federal funds trade over one session - was 4.98 per cent last Thursday, well below the 5.25 per cent target rate.

'Federal funds typically would move only 5 basis points around the target,' said Kenneth Kim, economist with Stone & McCarthy Research Associates, in Princeton, New Jersey.

Normally, 'maybe not until a day or two before the meeting you could see some slippage.' 'But these are extraordinary circumstances,' he said.

Since Aug 9, the Federal Reserve has added US$199 billion of temporary reserves to the banking system. These operations have eased the pain for banks struggling with the US subprime mortgage debt crisis and have also contributed to striking volatility in the overnight money market.

And, despite the sudden gap between the target and effective rates, some analysts say the recent moves in federal funds simply reflect those upheavals and fast-changing credit conditions.

'While the Fed may very well cut the funds target on the 18th, I don't think you can make the leap of faith that the effective fed funds rate being below target was the signal,' said Kevin Flanagan, fixed income strategist for global wealth management with Morgan Stanley in Purchase, New York.

In fact, the daily trading in the fed funds rate has been the most volatile since at least 1994, careening from effectively zero to as high as 6.05 per cent in just one session on Aug 10.

Before 1994, federal funds traded rates were a main tool for tracking Federal Reserve policy, and big swings then were a signal of a policy change. In 1994, though, the Fed adopted the current system of targeting a specific rate and announcing changes to its target the same day, as part of an effort to increase transparency to markets.

Since then, the effective rate has lost some of its predictive power, and for clues to pending rate moves investors have turned instead to rate futures markets.

Still, the current gap probably cannot continue for much longer. Either the Fed has to cut the target rate, as most now expect, or it has to ease up on the liquidity injections to allow the effective rate to float back up to a more typical spread. -- Reuters