New chapter for ultra low Fed funds rate

The Federal Reserve Tuesday, Dec. 16 switched to a range for its key target rate from 1 percent to a historically low range of zero to 0.25 percent, effectively cutting its key rate for overnight lending to banks by between 0.75 percent and 1 percent. The Fed also cut the interest it pays on reserves to 0.25 percent in an effort targeted at the traded fed funds market, where rates have been hovering close to zero.

Prior the announcement, the actual funds rate, which is charged on excess reserves banks lend to each other overnight, had already fallen to below 0.2%, well below target, in part because the banking system is awash with unneeded reserves. Therefore the FOMC is now aiming at a range rather than a level because of the difficulty of hitting the latter.

The Fed committed to keeping the target rate there for some time. It also said it will seek to support financial markets and the economy by measures that sustain the size of its balance sheet at a high level, listing a range of programs, from purchases of agency debt to mortgage-backed bonds to the possible purchases of Treasuries.

The central bank's policy panel, Federal Open Market Committee decision (FOMC), signals the end of interest rate cuts as a way to promote economic growth and points to the start of a new period in which expansion of the money supply has become the Fed’s primary tool. Having used up its conventional monetary firepower, it promised an unconventional strategy, such as the buying of mortgage-related securities and, possibly, Treasuries to lower long-term borrowing costs. Unconventional monetary policy is often called “quantitative easing” because its effect is felt through the quantity rather than the cost of credit. Through an array of lending programmes, the Fed’s balance-sheet has soared from below $900 billion to more than $2 trillion, and is about to grow further.

The Fed move is unlikely to have a huge impact for the repo market, a key secured lending market for banks and other financial institutions, as rates there have already plunged to low levels.

The Fed’s move should bring further relief to unsecured interbank lending markets. The London interbank offered rate has been falling since mid-October amid aggressive Fed efforts to provide liquidity to the financial system, and the key three-month Libor will likely plunge further. That’s good news for corporations and consumers, as Libor is the benchmark for adjustable-rate borrowing, including ARMs.

For money market funds, particularly those that invest mostly in Treasurys, the low level of fed funds and the Fed’s commitment to keep rates low for an extended period could create problems. Net yields, the returns these funds make on investments minus their expense ratios, could fall to zero or turn negative, forcing the funds to either waive fees or cut expenses to retain investors. Recently yields on Treasurys have fallen to historic lows. Just last week, three-month bill yields turned negative and an auction of four-week bills yielded zero.

The dollar fell sharply, particularly against the euro, after the Fed’s action. That may weaken the European Central Bank’s reservations about cutting rates again. Similarly, if the weaker dollar takes pressure off sterling, the Bank of England may be more willing to ease again.