- New overnight bank funding rate comes amid regulatory reform
- Could supplant fed funds rate if Fed balance sheet stays large
After eight years of unprecedented intervention in financial markets, the Federal Reserve has taken the first baby steps in a long-term mission to extract itself. But it’s good to have a backup plan just in case that doesn’t work out.
That’s one way to look at the new “overnight bank funding rate” the New York Fed unveiled Wednesday. The rate is intended to shore up the calculation that comprises the federal funds rate, a once-robust gauge of inter-bank borrowing costs that serves as the U.S. central bank’s monetary policy target, but has lost its significance as a barometer of underlying economic activity since the 2008 financial crisis.
The Fed’s cash injections into the financial system — through bond purchases that have added around $2.4 trillion to bank balance sheets — and a spate of new regulations, have combined to reduce inter-bank lending by 88 percent from its peak of $482 billion in September 2008, right before the crisis struck. As a result, less than 10 percent of transactions in what is left of the fed funds market are banks borrowing from each other to meet reserve requirements, according to the New York Fed.
“What the Fed is probably doing with the overnight bank funding rate is trying to, in essence, hedge for a future where the fed funds market never really does return to being a viable market again,” said Ward McCarthy, chief financial economist at Jefferies LLC in New York.
That could happen if policy makers opt not to wind down the central bank’s $4.5 trillion balance sheet, or if they don’t get the chance. The Fed has said it will begin shrinking the balance sheet when interest-rate increases are “well under way,” though a New York Fed survey shows dealers don’t expect this to happen for at least a year.
The home loan banks also have accounts at the Fed, allowing them access to the fed funds market. But because the Fed can’t legally pay them interest, they are forced to lend their excess cash into the market at rates below what the Fed pays.
To make the measure of market rates more robust, the new overnight bank funding rate will draw upon the $70 billion of daily transactions in fed funds, but will add a further $250 billion of eurodollar transactions to the mix. Both are calculated as a daily average of recorded trades.
“These new rates are a very important and positive development. The Fed is strengthening these rates through greater traded volume in the calculation,” said Tom Wipf, a managing director at Morgan Stanley in New York who is a member of the Alternative Reference Rates Committee, a Fed-sponsored group of market participants at the forefront of work on benchmark reform. “To the extent that we see changes in either one of those markets, the market is not overly reliant on a specific set of activities.”
One such scenario is negative rates, which have been adopted by central banks in Europe and Japan to spur growth and drive inflation higher. Chair Janet Yellen said last month the Fed is looking at them as a potential tool in a future crisis.
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