Media coverage the day following the Federal Reserve Open Market Committee’s (FOMC) action on October 30 widely applauded the Fed’s lowering of its target for the Fed Funds rate. The most important change in the October meeting was reducing the interest paid on bank reserves, the IOER, by 25 basis points, from 1.80% to 1.55%. This reduction in the IOER represents a smaller reduction than the September FOMC meeting and still leaves bank holdings of excess reserves too valuable in ensure a robust economy. However, this reduction at least leaves all Treasuries earning less than bank reserves, although marginally so. The spread between the 1-year Treasury and the IOER is now a mere 4 basis points, half of the spread achieved in September.
Media coverage continues to emphasize Fed statements about the Federal Funds Rate, despite the reality that the interest rate that matters most in the current monetary policy environment is the IOER. That rate is now 20 basis points below the upper bound of the Fed Funds target.
The press also emphasizes the role of the Fed in the determination of interest rates, but as the figure shows, the period of falling interest rates preceded the onset of any Fed reductions in the IOER. In fact, despite the reality of falling market interest rates that began in mid-November of 2018, the Fed raised both its upper Fed Funds target and the IOER in December 2018. Then with market interest rates continuing to fall, it made a minimal reduction in the IOER of 5 basis points in May 2019, with no change in the Fed Funds target. By that time the 10 year Treasury rate had fallen 27 basis points and the 1 year Treasury rate had fallen 8 basis points from their December 2018 levels. Importantly, both of these rates were below the IOER.
Finally, at its July FOMC meeting the Fed took action that recognized the (at that time) 8-month general fall in market interest rates and lowered both the IOER and Fed Fund target by 25 basis points. This change basically restored the Fed policy rates to their levels of early December of 2018. Then in September, it lowered the IOER by another 30 basis points while lowering the Fed Funds target by 25 basis points.
The FOMC’s announcement of this new interest rate paid on bank reserves, 1.55%, still leaves the return to banks for holding reserves just below the immediate close substitute, short-term treasury securities. The September 19 reduction in the IOER left all Treasury securities with maturities less than 2 years with interest rates below the IOER (then set at 1.80%). In contrast, this latest change in the IOER has the interest rate on all maturities of Treasuries above the IOER. The Fed has given banks at least a marginal incentive to move reserves to other higher-paying securities, a move that would expand the money supply. However, it is important to put this marginal superiority of Treasuries to excess reserves in perspective. Prior to the December increase in the IOER, the difference between the IOER and 10-year and 1-year Treasuries were respectively 59 and 44 basis points. Further, this was a period of rapidly declining bank holdings of excess reserves.
Finally, earlier in October there was an end to the inversion of the yield curve, where the 3-month and 1-year Treasury rates exceeded the 10-year rate. Many pundits breathed a sigh of relief, as such inversions have preceded the onset of the last three recessions, and during this time an inversion has never not been followed by a recession. However, the end of the inversion is in and of itself no reason for relief, as the last three recessions began an average of 4 months after the end of the interest rate inversion. While there is no reason to claim a direct causality running from an inversion to a recession, the yield curve inversion may signal bond market expectations of slowing growth and a heightened probability of a recession. In any event the sustained monetary expansion required to keep the economy on track requires that banks move excess reserves into the economy even if the inversion of the yield curve has ended.
The Fed’s cut of 25 basis points on Wednesday in both the Federal Funds rate target band and in IOER was not matched by interest rate movements, although short-term Treasury rates generally declined on Wednesday. The one-month rate declined by 5 basis points, the two-month rate by 7 basis points, and the three-month rate by 1 basis point. The one-year rate was unchanged, the two year rate declined by 3 basis points, the ten year rate by 6 basis points, and the thirty year rate by 7 basis points. Meanwhile, the early ‘betting’ on a rate cut in December is far from positive. The 30 day Federal Funds Futures Quote for December indicates market expectations of a federal funds rate of 1.555%, not much below the rate set today.