In the last post, I talked about how market moves even without the intervention of fed trading desk. This might have gave you an illusion that OMO is less important in the determination of effective fed fund rate. However, it is the very commitment that trading desk will use OMO to keep effective rate around targets that leads to the market forming expectation, and ultimately actualize the expectation. From the graph below we can see that, in the long run, fed trading desk has done a great job in keeping the effr around the target .
The average deviation of effr from target is about only 0.1 basis point. And there is evidence that the gap in between is shrinking overtime. This means that fed had become more and more apt at smoothing macro economic shocks. It could also mean that the market have been getting better and better at predicting the move of trading desk, out of the expectation that it will always follow the reaction function.
So there is obviously a gain for the forecaster who wants to forecast effective fed fund rate in the longer horizon. It is difficult for forecaster to use the traditional approach where supply and demand of fed fund is estimated and then the equilibrium fed fund rate is calculated. It is especially tenuous for forecaster to estimate the demand for federal funds. As I discussed earlier, demand for fed balance is now largely driven by loaning opportunities in hundreds of other markets, rather than driven by the need to fulfill legal reserve requirement. There is an interesting research paper about topology of fed fund market, where it shows that larger banks usually plays a role as fund buyers and smaller banks fund suppliers. Larger banks tend to have more credits and more lending opportunities. Those small banks fund larger banks by selling extra reserves. Thus it became harder and harder to trace out exactly how much each bank need the fed balance by simply looking at how much they need to hold at the Fed.
More importantly, since effective fed fund rate is moving closely around the target and policy makers set the targets manually, it is obvious that the fed has been playing more important role in determining the fed fund rate. Estimating demand is less important. The Federal Reserve Bank set the target rate to make sure sufficient credits are available for the economy, and they adjust the target rate according to a large set of other macro-economic indicators. The fed trading desk make sure effr does not go astray the target rate.
The fact that effr does not deviate fed target rate for too long and by too much is convenient for forecasting fed fund rate in the longer horizon. Now we can focus on forecasting the fed fund target rate. Fed fund target rate is determined by FOMC who keep track of bunch of macroeconomic indicators. If we can approximate the indicators used by them in making decision of next period fed fund target rate, we can also forecast the movement of fed fund target rate. Forecasting effective fed fund rate would, therefore, be roughly the same as forecasting fed fund target rate.