Friday, December 19, 2008

The End of Federal Reserve Open Market Operations As We Knew Them

It is being widely noted that the latest Fed interest rate cut pretty much uses up that tool for stimulating the economy, even though zero is a floor only in convention, and we have seen negative interest rates in fact. But there is more going on here than has been remarked on. To a substantial degree the latest Fed move involves covering up how seriously it has lost its ability to control the federal funds rate, its supposed main policy tool. The latest cut to 0-.25% simply moves the target down to where the actual ffr has been in recent weeks, well below the previous target of 1%.

The deeper problem is that the recent turmoil and decline of interest rates to near zero is collapsing the repo market. This point was made on Dec. 16 in "Ultra-low US rates undermine repo market" by Michael Mackenzie, also linked to on marginal revolution by Tyler Cowen. MacKenzie stresses the general problems for liquidity in financial markets arising from this collapse, but did not note the rarely made point that this has been the market where the Fed has generally carried out its open market operations that control the ffr. So, the collapse of this market may well be why the Fed has been unable to control the ffr, which fact they may now be trying to cover up. MacKenzie notes that a major problem in the repo market is that people borrowing securities from dealers are not returning them on time, leading to "failed trades." Also, the low rates leave too small spreads for the dealers to engage in intermediation. In any case, the Fed has lost its favorite policy tool.

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