How Low Will the Fed Funds U.S. Interest Rates Go

By: Hans_Wagner

On Wednesday October 29th, the Federal Reserve lowered the Fed Funds rate by 50 basis points to 1.0%. This comes on top of an earlier rate reduction on October 8, 2008 of 50 basis points. The rate is now at the level former Fed Chairman Alan Greenspan kept during 2003 and 2004. This raises the question can and should the Fed lower rates further?

The spread between the Fed Funds rate and other short-term rates is wide, reflecting the lack of sufficient capital by many banks. Further, the rising default rate by borrowers leads to wider spreads, as the banks that are lending are requiring higher rates to help account for the elevated risk. Should the Fed lower the Fed Funds rate another 50 basis points to 0.50%, it will lower the interest costs for the banks that use the overnight lending rate. In the past when the Fed lowered the Fed Funds rate, other longer-term rates tended to fall as well. For an economy that is struggling, lower borrowing costs should help to mitigate the affects of the recession and encourage it to recover.

Lowering the Fed Funds rate does not directly reduce the spread. The spread will narrow when confidence returns to the credit markets. It will take some time before this change in psychology will finally help reduce rates. Until then borrowers must wait for lenders to find the capital strength to increase their lending.

In 2003-2004, the Fed under then Chairman Alan Greenspan's leadership kept the Fed Funds rate at 1.0%. Recently, that strategy has been blamed for inflating the housing market and causing the excesses in the credit market that led to the current crisis. If rates are below 1.0% and kept there, we could be sowing the seeds of another bubble in the future.

Ordinarily, the Fed can keep the Fed Funds rate on target by adding or draining reserves from banks. The liquidity operations of the Federal Reserve have left banks with billions of excess reserves to lend out, forcing the Fed Funds rate well below target on most days. The Fed now pays interest on reserve deposits at 35 basis points below the Fed Funds rate target. Therefore, banks will leave reserves at the Fed once the market rate on Fed Funds falls to that deposit rate, which is the new de facto target. The Fed wants to maintain a 35 basis point spread between what it pays on reserves and the Fed Funds target rate. This will make it hard to get the funds rate target much below 0.5%.

If the Fed did set a zero Fed Funds rate, this action might encourage banks to leave their money at the Fed rather than lend it to each other, causing the Fed Funds market to dry up. Just the opposite of what the Fed wants to happen.

An unintended consequence of a Fed Funds rate below 1.0% would make it hard for money market mutual funds to pay a competitive yield and cover their operating expenses. If money market rates fall any further, money would flow out of money market funds and into government-guaranteed bank deposits, straining bank capital ratios.

The Fed is not likely to lower the Fed Funds rate below the current 1.0% rate. The consequences of lowering the rate further tends to worsen the current credit and money flow problems that the Fed is trying to correct. As a result, the Fed Funds rate is likely to remain at 1.0% rather than go any lower.

If you wish to learn more about analyzing the key factors that drive the economy, I suggest reading:

Economic Growth. by David Weil. An easy to read book that presents the key factors to understand global economies. It is expensive and is used as a textbook for college students, but it is worth the money.

By Hans Wagner
tradingonlinemarkets.com

My Name is Hans Wagner and as a long time investor, I was fortunate to retire at 55. I believe you can employ simple investment principles to find and evaluate companies before committing one's hard earned money. Recently, after my children and their friends graduated from college, I found my self helping them to learn about the stock market and investing in stocks. As a result I created a website that provides a growing set of information on many investing topics along with sample portfolios that consistently beat the market at http://www.tradingonlinemarkets.com/

Copyright © 2008 Hans Wagner

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