A 'Stealth Easing' by the Fed?

Despite some heavyweight industry opinion, there is no proof yet that the Federal Reserve is veering from its target for interest rates

Will the Federal Reserve rescue the economy and panicky financial markets by cutting interest rates? Some market commentators are arguing that it is already doing so, through an unannounced "stealth easing" of rates. These pundits note that although the Fed's stated target for the federal funds rate is still 5.25%, the actual rate has been averaging well below that this week. Economist Robert Brusca wrote Aug. 16 that: "At some point if this goes on for much longer the Fed will have no choice but to admit that it has eased."

But other close watchers of the Fed say that the central bank isn't doing any kind of stealth easing (see BusinessWeek.com, 8/8/07, "The Bernanke Agenda: Just Say No"). They say the Fed is still aiming for the federal funds rate to average 5.25%, but is having trouble hitting the target precisely with all the craziness going on in the markets.

One of the top authorities on the federal funds rate, Lou Crandall, chief economist of Wrightson ICAP in Jersey City, says, "I think that calling this a stealth easing is extremely misleading." ICAP (IAP), Wrightson's parent company, is the world's largest interdealer broker, so it keeps close tabs on the operations that the Fed uses to hit its target for the federal funds rate.

When in Crises

What makes Crandall so sure? One nontechnical reason is that the Fed has gone out of its way to cite the 5.25% target rate for federal funds. In past crises, including after the 1987 stock market crash, the Fed spoke in general terms about providing the system with plenty of "liquidity." The Fed could have done the same thing this time. By not mentioning the target rate, the Fed would have signaled the market with a wink and a nod that it was willing to let the funds rate drift below 5.25%. Instead, the Fed on Aug. 10 and the Federal Reserve Bank of New York on Aug. 16 specifically cited the 5.25% target. Says Crandall: "The Fed parses every syllable of those statements…for them to mention 5.25, that was an important point to them."

A bit of background: The federal funds rate is the rate that commercial banks charge each other for overnight loans of reserves. The Fed requires banks to have a certain amount of reserves to back up the demand deposits of their customers, such as checking accounts. Banks that are short on reserves borrow them from banks that have excess reserves. The rate for those overnight loans—i.e., the federal funds rate—varies depending on how much excess reserves there are floating around the banking system. The Fed can lower the federal funds rate by injecting more reserves into the banking system. It does that by buying securities such as treasuries from the banks. When a bank sells securities to the Fed, the Fed pays by crediting the bank with an increase in its reserve account.

The low rates for federal funds this week were pretty much guaranteed on Aug. 10, when the New York Fed, which conducts open-market operations on behalf of the Federal Reserve System, supplied lots of reserves to the market, says Crandall. While adding reserves is quick and easy, draining them takes much longer for a variety of technical reasons. "Once they flooded the system with reserves on that day [Friday], the low rates on subsequent days were inevitable," says Crandall.

Meet in the Middle

Brusca isn't backing down from his assertion that the Fed seems to be edging toward easier money. In an Aug. 16 interview, Brusca said, "If the Fed doesn't start hitting its target, this could turn into a stealth easing.… Unlike Lou [Crandall], I'm not so prone to take the Fed at its word." In other words, says Brusca, if he believes the Fed's target is 5.25% even though the actual funds rate stays consistently below that level, "at what point am I stupid?"

It could be that the truth lies somewhere between Crandall and Brusca. Kathleen Bostjancic, an economist at Merrill Lynch (MER) says in an interview that the Fed "is not purposely trying to hit a rate below the target. But they're going to be generous. They'll err on the downside. The last thing they want to do is have the funds rate go way above the target at a time like this."

The argument about the Fed's intentions could evaporate quickly if the effective funds rate does return to 5.25% and sticks there, but if it stays below the target much longer, expect to hear a lot more people talking about "stealth easing."

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