Best of the Week
Most Popular
1. US Housing Market Real Estate Crash The Next Shoe To Drop – Part II - Chris_Vermeulen
2.The Coronavirus Greatest Economic Depression in History? - Nadeem_Walayat
3.US Real Estate Housing Market Crash Is The Next Shoe To Drop - Chris_Vermeulen
4.Coronavirus Stock Market Trend Implications and AI Mega-trend Stocks Buying Levels - Nadeem_Walayat
5. Are Coronavirus Death Statistics Exaggerated? Worse than Seasonal Flu or Not?- Nadeem_Walayat
6.Coronavirus Stock Market Trend Implications, Global Recession and AI Stocks Buying Levels - Nadeem_Walayat
7.US Fourth Turning Accelerating Towards Debt Climax - James_Quinn
8.Dow Stock Market Trend Analysis and Forecast - Nadeem_Walayat
9.Britain's FAKE Coronavirus Death Statistics Exposed - Nadeem_Walayat
10.Commodity Markets Crash Catastrophe Charts - Rambus_Chartology
Last 7 days
AI Mega-trend Tech Stocks Buying Levels Q2 2020 - 1st Jun 20
M2 Velocity Collapses – Could A Bottom In Capital Velocity Be Setting Up? - 1st Jun 20
The Inflation–Deflation Conundrum - 1st Jun 20
AMD 3900XT, 3800XT, 3600XT Refresh Means Zen 3 4000 AMD CPU's Delayed for 5nm Until 2021? - 1st Jun 20
Why Multi-Asset Brokers Like TRADE.com are the Future of Trading - 1st Jun 20
Will Fed‘s Cap On Interest Rates Trigger Gold’s Rally? - 30th May
Is Stock Market Setting Up for a Blow-Off Top? - 29th May 20
Strong Signs In The Mobile Gaming Market - 29th May 20
Last Clap for NHS and Carers, Sheffield UK - 29th May 20
The AI Mega-trend Stocks Investing - When to Sell? - 28th May 20
Trump vs. Biden: What’s at Stake for Precious Metals Investors? - 28th May 20
Stocks: What to Make of the Day-Trading Frenzy - 28th May 20
Why You’ll Never Get Another Stimulus Check - 28th May 20
Implications for Gold – 2007-9 Great Recession vs. 2020 Coronavirus Crisis - 28th May 20
Ray Dalio Suggests USA Is Entering A Period Of Economic Decline And New World Order - 28th May 20
Europe’s Coronavirus Pandemic Dilemma - 28th May 20
I Can't Pay My Payday Loans What Will Happen - 28th May 20
Predictive Modeling Suggests US Stock Markets 12% Over Valued - 27th May 20
Why Stocks Bear Market Rallies Are So Tricky - 27th May 20
Precious Metals Hit Resistance - 27th May 20
Crude Oil Cuts Get Another Saudi Boost as Oil Demand Begins to Show Signs of Life - 27th May 20
Where the Markets are heading after COVID-19? - 27th May 20
Silver Springboards Higher – What’s Next? - 26th May 20
Stock Market Key Resistance Breakout Is Where the Rubber Meets the Road - 26th May 20
5 Ways To Amp Up Your CFD Trading Today - 26th May 20
The Anatomy of a Gold Stock Bull Market - 26th May 20
Stock Market Critical Price Level Could Soon Prompt A Big Move - 25th May 20
Will Powell Decouple Gold from the Stock Market? - 25th May 20
How Muslims Celebrated EID in Lockdown Britain 2020 - UK - 25th May 20
Stock Market Topping Behavior - 24th May 20
Fed Action Accelerates Boom-Bust Cycle; Not A Virus Crisis - 23rd May 20
Gold Silver Miners and Stocks (after a quick drop) Ready to Explode - 23rd May 20
3 Ways to Prepare Financially for Retirement - 23rd May 20
4 Essential Car Trade-In Tips To Get The Best Value - 23rd May 20
Budgie Heaven at Bird Land - 23rd May 20
China’s ‘Two Sessions’ herald Rebound of Economy - 22nd May 20
Signs Of Long Term Devaluation US Real Estate - 22nd May 20
Reading the Tea Leaves of Gold’s Upcoming Move - 22nd May 20
Gold, Silver, Mining Stocks Teeter On The Brink Of A Breakout - 21st May 20
Another Bank Bailout Under Cover of a Virus - 21st May 20
Do No Credit Check Loans Online Instant Approval Options Actually Exist? - 21st May 20
An Eye-Opening Perspective: Emerging Markets and Epidemics - 21st May 20
US Housing Market Covid-19 Crisis - 21st May 20
The Coronavirus Just Hit the “Fast-Forward” Button on These Three Industries - 21st May 20
AMD Zen 3 Ryzen 9 4950x Intel Destroying 24 core 48 thread Processor? - 21st May 20
Dow Stock Market Trend Analysis and Forecast - 20th May 20
The Credit Markets Gave Their Nod to the S&P 500 Upswing - 20th May 20
Where to get proper HGH treatment in USA - 20th May 20
Silver Is Ensured A Prosperous 2020 Thanks To The Fed - 20th May 20
It’s Not Only Palladium That You Better Listen To - 20th May 20
DJIA Stock Market Technical Trend Analysis - 19th May 20
US Real Estate Showing Signs Of Covid19 Collateral Damage - 19th May 20
Gold Stocks Fundamental Indicators - 19th May 20
Why This Wave is Usually a Market Downturn's Most Wicked - 19th May 20
Gold Mining Stocks Flip from Losses to 5x Leveraged Gains! - 19th May 20
Silver Price Begins To Accelerate Higher Faster Than Gold - 19th May 20
Gold Will Soar Soon; World Now Faces 'Monetary Armageddon' - 19th May 20

Market Oracle FREE Newsletter

Coronavirus-stocks-bear-market-2020-analysis

U.S. Fed Fears Loss of Power in Preventing Financial Collapse

Interest-Rates / US Interest Rates Oct 10, 2008 - 08:29 AM GMT

By: Money_Morning

Interest-Rates

Best Financial Markets Analysis ArticleShah Gilani writes: The truth? You can't handle the truth.”

The truth is, the U.S. Federal Reserve does not directly control the Federal Funds rate, and its efforts to reduce the benchmark rate from 2.0% to 1.5% may do more damage than good – though for reasons you'd never guess. Attempts to lower the Fed Funds rate could irreparably damage Fed credibility and may actually narrow the Fed's credit-crisis-management options.


The Fed Funds rate is the interest rate that banks charge one another for overnight loans. Under normal circumstances, the Fed Funds rate is the central bank's primary and most effective tool in influencing interest rates. But the current market situation is anything but normal.

Contrary to what most people think, the Fed Funds rate is a “ target;” it is not an absolute number that anyone actually has to follow . The central bank's policymaking arm, the Federal Open Market Committee (FOMC), resulting principally from its deliberations on the outlook for inflation, and secondarily the general state of the economy, raises and lowers interest rates throughout the financial system and the economy by targeting the Fed Funds rate.

Before the U.S. financial markets opened on Wednesday, Fed policymakers, headed by Chairman Ben S. Bernanke, announced that the central bank was lowering the Fed Funds rate half a percentage point to 1.5%. The idea is that, the lower a bank's cost of money actually is, the cheaper the rate at which it can lend to others and still maintain a decent profit margin [For a complete discussion of cost of funds, and of the overall lending process, take a look at yesterday's Money Morning report on the commercial paper market . The report is free of charge.]   Banks compete with each other to make loans. If they have lots of money to lend, they compete for business by lowering the interest rates they charge borrowers. The more money banks have, the lower interest rates go.

If the Fed lowers the rate at which banks borrow from one another, it stands to reason that banks will generally pass their lower cost of money along to borrowers. And that means the lower resulting interest rates will stimulate capital formation, production and consumption – and with it, the entire U.S. economy.

Well, at least that's what's supposed to happen. But here's how it really works.

 Every major bank has a Fed Funds trading desk. The job of a bank's Fed Funds trader is to buy or sell money overnight, or for longer periods. There are two reasons why banks buy and sell money:

  • First, if a bank has money in its vault that it could – but hasn't – lent out, that money does the bank no good just sitting there, not generating any interest income for the institution. So the bank's trader actually calls around to other banks to see who wants to borrow some money.
  • The second reason is actually far more critical and is always the bank's first consideration: The Federal Reserve requires that banks keep at least a specified minimum of reserves in their vaults. That means that each and every evening, as the Fed tucks a bank in for the night, it always makes sure to ask: “Have you met your reserve requirements tonight?” If a bank has made a lot of loans that day, it may be short of cash to meet its reserve requirement ratio. If that happens, the bank's Fed Funds trader calls other banks and borrows enough money to cover its reserve requirements.

Generally speaking, the interest that banks charge each other is close to what we know as the Fed Funds rate. If the Fed lowers the Fed Funds rate, theoretically the cost of money at which banks lend to one another is lower, too. In theory, then, if all banks have met their reserve requirements, and if they all have money to lend to each other overnight, and because money that doesn't get lent out doesn't make any interest, banks will lower interest rates for borrowers so that the money in their vaults is put to use and earns interest.

Here's the rub. In order for the Fed to actually change the Fed Funds rate, it must itself go out into the market and buy and sell securities. The Fed executes open market operations through the New York Federal Reserve Bank, the most powerful of the 12 Federal Reserve Banks.

If the Fed wants, as it does now, to lower its Fed Funds target rate, it has to initiate the process. In order to add cash into the banking system, the New York Fed buys Treasuries from dealers and pays cash. The transaction is called a repurchase agreement , or “repo.” The result of this transaction, when done to the tune of billions of dollars, is that dealers now have billions in cash that they can deposit into banks. Since, banks theoretically now have a lot of cash to lend to one another overnight, they will lower the overnight rate that they charge each other.

The Fed must inject enough excess cash into banks' vaults through its open-market repo operations to make sure the banks actually lower the overnight rates they charge one another until that rate approximates the central bank's Fed Funds target rate . That's the reality of how the target rateis reached.

But, as usual, there's the story – and there's the story behind the story.

Traditionally, when the Fed executes repurchase agreements, it buys U.S. Treasuries and pays cash for them. The Treasury securities the central bank buys becomes part of its balance sheet. Now, however, dealers and banks are loath to sell any Treasuries. Why? Because Treasuries are the only security on dealers' and banks' balance sheets whose actual worth they know. They're not parting with them.

Because the Fed is determined to add liquidity by providing loans and easily marketable securities to banks and dealers through its discount window and term auction facility , it is already taking in all manner of other securities, including equities, against which the Fed is lending Treasuries from its own balance sheet. If the Fed wants to lower the Fed Funds rate, and dealers and banks aren't going to sell it any Treasuries, the central bank will have to take in other securities (toxic junk) as collateral against the cash that it hopes to inject into the banking system through its repurchase agreements.

Just how depleted and how damaged the Fed's balance sheet may become is a major concern. But, that's not the immediate problem.

Lowering the Fed Funds rate may not work at all.

Just because the Fed floods banks with cash doesn't mean that banks will lend each other money – at the targeted Fed Funds rate, or at any rate. Banks are all fearful of each other – I'm talking on a worldwide basis – they are increasingly hoarding cash as a cushion against their own upcoming losses. They're facing increasing weakness in their commercial-loan and commercial mortgage-backed securities inventories (the next shoe to drop). And banks are increasingly facing heightened exposure to leveraged loan portfolios on their books that they can't off-load, and rapidly deteriorating credit-card-based securities and portfolios.

If the Federal Reserve is unable to facilitate overnight-bank lending, and is unable to actually lower the Fed Funds rate to its target rate of 1.5%, what will that do to its credibility? It is devastating that we have no trust in our banks; but if we also lose trust in our central-bank firefighter's ability to quell the financial conflagration, the darkening skies may make the last three weeks seem only partly cloudy.

The Fed and the U.S. Treasury Department have done a good job in addressing, publicly, what needs to be done. Unfortunately, they have both made the cardinal sin of actually showing us their hands, when they should have played their aces earlier and controlled the game.

Now the whole world is watching.

And since we know the hand we're all playing, it's only a matter of what cards are turned over that will determine our future.

On Monday, I'll show you the Treasury's hand and tell you why that game is already lost.

We need to drop these games, reshuffle the cards and play this out as the “house” with greater odds in our favor. It can be done by Election Day, but we're going to have to take the politics out of the game – once and for all.

Can we do it?

[ Editor's Note : Contributing Editor R. Shah Gilani has toiled in the trading pits in Chicago, run trading desks in New York, operated as a broker/dealer and managed everything from hedge funds to currency accounts. In his just-completed three-part investigation of the U.S. credit crisis, Gilani was able to provide insider insights that no other financial writer or commentator could hope to match. He drew upon the experiences and network of contacts that he developed through the years to provide Money Morning readers with the "real story" of the credit crisis – and to propose an alternate plan of action . It's a perspective on the near-financial meltdown that more than 140,000 readers have already read – and an insight that you'll find nowhere else.

If you missed Gilani's investigative series, Part I appeared Sept. 18 , Part II ran Sept. 22 and Part III was published Sept. 24 . Gilani's plan was published on Sept. 25 as an open letter to U.S. Treasury Secretary Henry M. “Hank” Paulson Jr. It actually contains contact information for readers who still wish to protest the government's action with the bailout bill by passing their disenchantment along to their elected representatives in each state's governor's mansion, and in both the House and the Senate. Check out Gilani's plan of action .

With the U.S. financial markets in such disarray, Money Morning is looking for profit opportunities beyond U.S. borders: For instance, just check out this new report on a Wisconsin-based company we've discovered that's posting quarter after quarter of earnings surprises - while the rest of Wall Street tanks. Not only does this company have a lock on China - the fastest-growing market on the planet - this corporate gem is also riding the profit wave of the most-powerful global trend that we're following right now. If you act on this opportunity now - as an added bonus - you'll also receive a free copy of CNBC analyst Peter D. Schiff's New York Times best-seller, " Crash Proof: How to Profit from the Coming Economic Collapse ." ]

News and Related Story Links:

By Shah Gilani
Contributing Editor

Money Morning/The Money Map Report

©2008 Monument Street Publishing. All Rights Reserved. Protected by copyright laws of the United States and international treaties. Any reproduction, copying, or redistribution (electronic or otherwise, including on the world wide web), of content from this website, in whole or in part, is strictly prohibited without the express written permission of Monument Street Publishing. 105 West Monument Street, Baltimore MD 21201, Email: customerservice@moneymorning.com

Disclaimer: Nothing published by Money Morning should be considered personalized investment advice. Although our employees may answer your general customer service questions, they are not licensed under securities laws to address your particular investment situation. No communication by our employees to you should be deemed as personalized investment advice. We expressly forbid our writers from having a financial interest in any security recommended to our readers. All of our employees and agents must wait 24 hours after on-line publication, or 72 hours after the mailing of printed-only publication prior to following an initial recommendation. Any investments recommended by Money Morning should be made only after consulting with your investment advisor and only after reviewing the prospectus or financial statements of the company.

Money Morning Archive

© 2005-2019 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Post Comment

Only logged in users are allowed to post comments. Register/ Log in

6 Critical Money Making Rules