Thursday, September 13, 2007

A (Not So) Secret Rate Cut?

Felix Salmon, William Polley, David Gaffen and Nouriel Roubini began a discussion last month, now continued at Greg Mankiw's blog, about whether the Fed has already cut the Fed Funds rate target without announcing it. The evidence for an implicit cut is that the Effective Fed Funds rate has averaged only 4.97% since August 10 (data here), versus an official target of 5.25%:

The innocent explanation for this, which most people except Roubini seem to be accepting, is that the increased volatility in the fed funds market has made it harder for the Fed to hit its target, so they're simply erring on the side of caution.

I don't think that's what's happening for two reasons.

First, there have been other periods of volatility in the fed funds market that didn't produce significant under- or over-shooting of the target rate. The picture below shows the scatterplot of absolute deviations of the daily effective fed funds rate from the target versus the intraday fed funds range (high minus low) since July 2000. I've removed the Sept 11, 2001 outliers, though it doesn't change much if you leave them in. The data since Aug 10th is bolded, and the straight line is the regression using pre-Aug 10 data.

The Fed's undershooting clearly is not purely a result of higher intraday volatility.

Second, the Fed can intervene in the fed funds market as often as it wishes. Typically it only does so once a day in the morning, but it can and occasionally has conducted open market operations more frequently intraday. So if the Fed really wanted to hit a 5.25% target, it could.

The conclusion I'm forced to make is that the Fed is hitting its target, but that target is 5%.


knzn said...

Possibly the Fed is hitting a target of 5.25%, but that target is not really for the effective federal funds rate, but perhaps for the median federal funds rate (which, as far as I know, isn't reported). I don't know offhand when those other periods of volatility occurred, but I would guess that they may have been quite a bit less skewed than the current volatility. (Since we observe that the average is much closer to the top of the range in the recent data, we can conclude that the recent distributions have been skewed downward, so that the median has been higher than the average.)

HopefullyGrowing said...

I am much an amateur, but nonetheless curious. . . why would the fed want to hit an FFR different than the stated target?

knzn said...

Looking at the data now, my hypothesis about skewness appears to be wrong. What I do notice, though, is that the other points with wide ranges are almost all isolated days rather than extended periods. If you use 5-day moving averages, the picture looks very different, and the recent data are not out of line. I'm not sure what that means, though.

Marc Shivers said...

hfg: Good question. If I had to guess, I'd say they wanted to ease policy, but didn't want to officially cut the target rate between meetings, especially when they had a hiking bias at the previous meeting just a few days earlier.

knzn: Even with a 5DMA, the recent points are still seem a bit out of line, though, as you say, there are fewer historical precedents. I'm not sure though why a MA is an interesting thing to look at. The point remains that regardless of how one tortures the data, they still say something unusual is happening.

psummers said...

Although there does seem to be something strange happening in the fed funds market, the problem I have with the "stealth easing" story is that it just doesn't square with Bernanke's reputation for openness and transparency. I think he's been a straight shooter since he started this job, and from what I've seen it seems like if he wanted to cut the funds rate, he'd have said so.

knzn said...

After looking at the data and thinking about it, I'm pretty much convinced that the Fed could have hit the 5.25% target if that had been its priority. But I don't think that premise justifies the conclusion that "the Fed is hitting its target, but that target is 5%." Rather, the Fed has temporarily changed its priorities such that hitting any funds rate target is no longer at the top of the list. In fact, the data are not consistent with the assertion that the Fed is hitting a 5% target: looking at the actual effective funds rate, you would have to conclude that the Fed's target is changing almost every day. Sometimes it is closer to 4.75%, sometimes 5%, and sometimes it seems to go back to 5.25%. A more parsimonious conclusion is that the Fed is not targeting the federal funds rate at all.

I believe, though, that the Fed is still targeting 5.25% but that it has other concerns that temporarily have priority over that target. One possibility is that the Fed cares about both the level of reserves and the federal funds rate, but that, under normal conditions, reserves vary so little around the Fed's target to make that target effectively irrelevant, whereas today, either the Fed has tightened its reserves target, or reserves have been coming up uncharacteristically short of the target, making that one the "binding constraint".

Marc Shivers said...

psummers & knzn: True, the conclusion is a bit glib and sound-bitey and I wouldn't want to have to defend it in any literal sense. On the other hand, it's clear to me that they aren't trying to target 5.25%, even modulo some noise. The question, which I think might have to wait for Bernanke's autobiography, is what are they trying to target. It's clearly not any fixed rate.

David said...

I believe the FOMC will cut at the next meeting, but not that they have cut so far. All of the suppression of the Fed funds rate has been done by temporary intervention. A 25 bp cut, combined with a permanent injection of liquidity, would be favorably received by the market, because they would know it would stick. The last permanent injection of funds was on 5/3.

That said, it wouldn't be as good for the market as 50 bp, but I can't see them moving so fast.