"If money isn't loosened up, this sucker could go down" - George W. Bush warned in September 2008

Friday, November 12, 2010

Collapse of the Fed Funds Rate Peg and the Great Recession

The causes of the Great Repression are still a matter of active debate among economists, and Scott Sumner, in a post directed at me, says "the interest on reserve policy was a huge mistake, comparable to the 1936-37 decision to double reserve requirements in the midst of the Great Depression". Here I will attempt to show that the primary cause of the Great Recession was the collapse of fed funds rate peg after the bankruptcy of Lehman Brothers. The second most important cause of the Great Recession is related to the imperfections of interest rate targeting regime that was too closely associated with backward looking Taylor rules. And the interest on reserves program was not a cause of the Great Recession, it was one of the first "green shoots".

The collapse of fed funds rate peg is clearly visible in a chart below. This collapse was seen by markets as a regime change that led to deflationary expectations.

When the standard deviation of effective fed funds rate is so huge, volume weighted average of fed funds rate transactions is no longer a reliable indicator of fed funds rate. As October 2008 FOMC minutes put it, "In the overnight federal funds market, financial institutions became more selective about the counterparties with whom they were willing to trade." Fortunately, overnight LIBOR is an indicator of fed funds market that does not have a participation bias:

Breakdown of fed funds rate market has led to market expectations of elevated future cost of fed funds, and October 2008 FOMC minutes indicated that "the spread of term Libor rates over comparable-maturity overnight index swap (OIS) rates rose sharply from already-high levels". Here is a chart that compares three month Libor to fed funds rate target:

The inadvertent tightening of monetary policy that was caused by the breakdown of fed funds rate market was a matter of great concern for policymakers. On September 18 2008 a $180 billion monetary expansion was announced. The need for softer monetary conditions was communicated to President Bush, who understood the danger and said "If money isn't loosened up, this sucker could go down".

The key instrument that lowered the cost of fed funds was interest on reserves. Start of interest on reserves program led to the announcement of October 13, 2008, on that date the Fed promised to supply unlimited quantity of reserves until the policy objectives have been met. After the announcement overnight Libor and three month Libor rates started falling.

On October 22, overnight Libor finally fell to the rate consistent with the fed funds rate target, and on that date the Fed increased interest paid on reserves to prevent effective fed funds rate from falling further. This was a mistake for two reasons. First, the fed funds rate peg was not completely credible on that date according to three month Libor, and for this reason the expected future cost of reserves was higher than the target. Second, the fed funds rate target as set by the FOMC was too high at that time according to Svenssonian forward looking approach.

Related post: Should Fed stop paying interest on reserves?

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