A New Fed Plot Twist?

I thought I had heard every possible outcome of this week’s Fed meeting, but I heard an interesting new scenario yesterday from a bond specialist at the largest asset management firm in the world.

Right now, we all say that interest rates are at zero and that the Fed is engaged in a ‘zero interest rate policy,’ or ZIRP.  That’s not quite true though, the fed funds target rate, as set by the Federal Open Market Committee (FOMC), is actually a range from 0-0.25 percent.

Let’s take a step back for a moment before getting into the new twist and start with the basics.

When banks take deposits from customers, they loan most of the money out and earn the difference between what they charge for their loans and what they pay their depositors.

They can’t loan all of the money out and have to keep roughly 10 percent in reserve (this calculation gets complicated, but 10 percent is a good example).  That 10 percent capital has to be held as cash in the vault (which is uncommon anymore) or at the Federal Reserve.

If the bank is a little short of that 10 percent threshold, they can borrow money from the Fed or from other banks to shore up their capital or face penalties from the Fed.  Conversely, if another bank has a little excess over their reserve, they can lend it to the bank in need and earn a little interest.

All of these loans are done at the Federal Reserve and are typically just overnight loans.

If a bank that is short on reserves borrows from the Fed, they have to pay what is called the discount rate, which is currently 0.75 percent.  That’s obviously more expensive than the federal funds target rate of 0-0.25 percent, so banks have a real incentive to borrow from each other instead of the Fed.

That also means that the Fed can’t directly control the fed funds rate, since it is determined between the banks.  They do have a powerful tool at their disposal in that they interact with the market in what is called open market operations.

If the fed fund rates go much above the target rate set by the FOMC, then the Fed will enter the market and effectively create money by selling bonds and increases the amount of money in the system.

If the fed fund rate falls below the target range (when it isn’t zero), the fed enters the open market, buys bonds and takes money out of the system.

So here’s the twist: until the Fed cut rates to their current level, the fed funds rate was a single number, and not a range.  The possibility that I heard today for the first time was that the FOMC would raise rates to a higher range.

I have said that I wouldn’t be surprised if they took rates from 0-0.25 percent to simply 0.25 percent.  This new range concept throws that possibility out the window and creates the possibility of higher rates because the next step higher from here would be 0.25-0.50 percent.

It makes sense because the actual fed funds rate between banks does shift around somewhat – yesterday the effective fed funds rate was 0.14 percent, smack dab in the middle of the range.

To be perfectly honest, I’m not entirely sure what the implications of a target range would be versus a single target rate.  I suspect that it wouldn’t change much in terms of actual lending and borrowing between banks and it would give the Fed more flexibility, but I can’t say what markets would think of such a move.

It was a surprise to me, so it could be a surprise to the market, I can’t say.  Now, I’m trying to think of new twists, like from the Sixth Sense, the Usual Suspects or Citizen Kane.

The only thing that I can come up with is that they abandon increments of a quarter-percent.  What would we all think if the new range was 0.15-0-0.35 percent?  More shocking than finding out that Norman killed his mother!