Another “Nuts & Bolts” Description of How the FOMC Works

In case you are wondering how the FOMC actually injects cash into the market place, the article from the WSJ.com/Economics (8/16/07 post) gives an excellent description. This ties in really well with two earlier post about injecting capital into the markets and recent trends in the Fed Funds rate market.

As a side note the content of WSJ.com/Economics is very good and it provides an excellent service to the investing public. It often covers subjects that you had in school, but if you don't work with everyday they get away from you over time. If you are surfing the net on economic/business related issues this is always a good spot to land just to see what's new. This blog is a relatively new service for the WSJ. I hope they see fit to keep it up and running (and free).

Much has been made in recent days about the deviation between the actual fed funds rate charged on short-term loans and the target set by the Federal Open Market Committee, with some going so far as to call it a de facto rate cut. How does the Fed keep the actual rate near its target, and what does the recent deviation mean? Here’s a primer.

The fed funds rate is the rate banks with excess reserves charge when they lend money to other banks overnight. It moves according to a traditional supply-demand path. When there are more institutions looking to borrow than lend, the rate goes up. When there are more lenders, it goes down. The Federal Reserve sets a target for this interest rate, and the Trading Desk at the Federal Reserve Bank of New York adds or drains funds to keep the rate near its target, which is now 5.25%.

Each morning, reserve forecasters at the New York Fed and at the Board of Governors in Washington compile data on bank reserves for the previous day and make projections of factors that could affect reserves for future days. They consult with Treasury Department officials, and then the Trading Desk officials in New York make a plan for the day. The plan is then reviewed by at least one voting FOMC member.

At this point, the Trading Desk prepares to enter the market to execute repurchase agreements (temporary purchases of securities from the dealers, who agree to repurchase them on a specified date at a specified price) or, more rarely, reverse repurchase agreements (temporary sales of securities). The recent Fed actions have all been repurchase agreements.

The Desk sends an electronic message to all of the primary dealers (21 large banks and securities brokerages that trade with the Fed), asking them to submit bids or offers within 10 to 15 minutes. The message states the term of the operation, but doesn’t specify its size. The size of the operation is announced later, after the operation is completed. The dealers’ propositions are evaluated on a competitive best-price basis. Primary dealers whose offers have been accepted, and those whose offers have been turned down, are notified of the results, usually about five minutes after the bids or offers were due.

The Desk accepts bids of varying rates and sizes, aiming to keep the average rate near the FOMC target. However, this process is filled with uncertainty — especially at times of market turmoil — and trades between institutions outside of the repurchase agreements can move the rate. The Desk may also make agree to deals with rates below the target on a given day, while still aiming to keep the rate at the Fed’s target over the longer term.

The Fed’s recent wave of repurchase agreements came as the market had driven the average actual rate above the FOMC target. The infusion of liquidity has brought the average actual rate below 5.25% in recent days, at some points approaching zero. In fact, it has been just below 5% since the Fed began pumping funds into the market last week.

This doesn’t mean the Fed wants the rate to remain below its target. One possible explanation is that the central bank is erring on the side of caution, temporarily overshooting its goal of a lower rate while the liquidity situation returns to normal.

Another possible factor keeping the rate down is transactions between dealers outside of the Fed’s repurchase agreements. Some trades have taken place at rates near 0% over the last few days. These trades don’t represent the majority of transactions, but may be dragging down the average rate.