The Fed and interest rates

Despite increasing turbulence throughout the financial markets, both domestically and internationally, the Federal Reserve’s policy committee, as expected, decided last Tuesday to keep the federal funds rate (the interest rate banks charge each other for overnight loans) at 5.25 percent. It was the right decision.

The Fed then spent the last two days of last week vigorously defending the 5.25 percent rate. That defense continued yesterday. Through its open-market operations, the Fed injected $24 billion of liquidity on Thursday and another $38 billion on Friday. These are huge amounts, recalling the actions the Fed took on September 11, 2001, when the entire system threatened to freeze up.

Rather than conducting one open-market operation each day, which is customary, the Fed intervened twice on Thursday and three times on Friday. Moreover, in its use of repurchase agreements to conduct its liquidity-enhancing operations, the Fed raised some eyebrows by accepting mortgage-backed securities as collateral. Normally, U.S. Treasuries and U.S. agency bonds (e.g., Fannie Mae and Freddie Mac) serve as collateral, but last week the Fed agreed to accept high-quality mortgage-backed securities that were guaranteed by Fannie and Freddie. This was unusual, but not at all unprecedented. Contrary to speculation, the Fed did not accept securities backed by subprime mortgages, some of which comprise the toxic waste that precipitated the long-overdue repricing of risk that has been taking place in recent weeks.

Under the circumstances, the Fed is acting appropriately. Note well: In response to the turbulence, the Fed has not lowered the federal-funds rate of 5.25 percent, which, it bears repeating, is a mere quarter-point above the six-month annualized consumer-price inflation rate of 5 percent. That calculation yields a real (inflation-adjusted) fed-funds rate of 0.25 percent. Given that the U.S. economy will soon enter its seventh year of expansion, a real fed-funds rate of 0.25 percent hardly seems overly restrictive, even under the current turbulent circumstances.

When markets opened Friday, the fed-funds rate had jumped to 6 percent, 75 basis points (each percentage point comprises 100 basis points) above the Fed’s target. As it happened, it took nearly $40 billion in additional reserves to force the rate back down. Meanwhile, the market for high-quality mortgage-backed securities had drastically deteriorated in response to the subprime debacle. In the understandable rush to liquidity, holders of these solid assets would have had to unload them at fire-sale prices. Conceivably, the effect might have been to pour gasoline on an already-spreading fire. Thus, the Fed was right to accept them as collateral, as it has in the past.

Using open-market operations to enforce its targeted overnight interest rate is what the Fed does.