Federal Reserve officials haven’t decided when to raise short-term interest rates, but as The Wall Street Journal reported earlier this week, they are closer to finishing a blueprint for how they’ll do it.
Minutes of the Fed’s July 29-30 policy meeting laid out fresh details and elaborated on others. Among the big winners in the new approach–as we’ll explain lower in this post–are foreign banks.
But first the details:
The most striking feature of the Fed’s strategy is that it keeps in place an effective subsidy that the U.S. central bank is currently paying to foreign banks.
Here’s how:
In recent years foreign banks have been tapping U.S. money market funds for very cheap short-term loans. Unlike domestic banks, foreign banks don’t have domestic depositors to tap for funds, so they turn elsewhere for dollars. Money market funds make the funds available for a few hundredths of a percentage point. The foreign banks in turn park those loans at the Fed for 0.25% interest. They earn profits on the spread between the cheap cost of funds available from money market funds and the higher rate they get at the Fed.
It’s a trade that domestic U.S. banks have been unwilling to make because they have to pay additional fees to the Federal Deposit Insurance Corp. on their borrowings, fees the foreign banks don’t have to pay. “A change in the calculation of the Federal Deposit Insurance Corporation (FDIC) deposit insurance fee in 2011 likely reinforced the relative attractiveness of fed funds borrowing for foreign banks (which are generally not FDIC insured) versus domestic banks,” New York Fed economists found in a study last year. Foreign banks accounted for nearly 60% of fed funds market trading in 2012, according to the New York Fed study.
By keeping a quarter-percentage-point spread in place between money market funds and commercial banks with its new system, the Fed is effectively keeping in place a structure that allows foreign banks to profit where domestic U.S. banks can’t.
“The wider spread is primarily a gift to foreign banks,” said Louis Crandall, a money market analyst with Wrightson ICAP.
Another striking feature of the Fed’s evolving strategy is its broader reliance on the federal-funds market, where banks make short-term loans of reserves to each other overnight. The Fed has used the fed-funds rate as its benchmark short-term interest rate for many years. But some analysts wonder of this market is outdated.
This market is awash in cash due to the Fed’s efforts to pump money into the banking system. Because banks have so much cash, the fed-funds market where they tap reserves experiences very little day-to-day trading. One New York Fed study shows daily trading volume in the market has contracted from an already-thin $200 billion before the financial crisis to nearly $50 billion. Moreover, traditional U.S. commercial banks are especially inactive. The most active players are government sponsored Federal Home Loan Banks and foreign banks.
“The fed funds market is but a shadow of what it was prior to the crisis,” Raymond Stone, an analyst at Stone McCarthy Research, said in a note to clients Wednesday. “It is no longer clear that the funds rate is the key determining factor of the behavior of short-term interest rates.”
Fed officials don’t want to abandon the fed-funds rate, in part because the values of many derivatives contracts are tied to it, and in part because they are used to it being their key tool for influencing short-term rates. “Almost all participants agreed that it would be appropriate to retain the federal funds rate as the key policy rate,” the minutes said.
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