Tag Archives: rational expectaion

Fed fund rate: not as simple as it seems. (4th post)

In my last post, I talked about the fact that effective fed fund rate move even without OMO actually taking place, bringing the fed fund rate towards its new targets. This might have gave you an illusion that the market is moving without the intervention of fed. 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. That is to say, the fed stir up market sentiments to cooperatively bring effective fed fund rate towards target rate.

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 (click on the graph to view the original image). fredgraph

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, meaning 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 want 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 funds are estimated and then the equilibrium fed fund rate is calculated. It is especially a tenuous task for forecaster to estimate the demand for federal funds. As I discussed in my second post, 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 play 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 their 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.

Fortunately, the Federal reserve bank economists had done the job for us. Fed had already estimated the total liquidity and corresponding amount of fed balance needed by banking system, and they set the target rate to make sure sufficient but not overwhelming credits are available for the economy. To make sure of this, the effr must not go astray the target rate. The fed trading desk make sure of this by performing OMO everyday in the market. The fact that effr does not deviate fed target rate for too long and by too much is convenient, since now we can just forecast the fed fund target rate. As we all know,  fed fund target rate is determined by fed official who keep track of bunch of macroeconomic indicators.  If we can approximate the indicators used by Fed 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.