EC Right On Cue, Low Money Rates Are Not What You Might Think

But what happens on Day 3 shows that a lower rate doesn’t necessarily mean things are getting better. In fact, in this situation, the reduction in the average is dangerously deceptive.

Because cash suppliers have grown even more risk-averse, they begin to differentiate among individual opportunities (counterparty risk). They might simply avoid lending even a single dime to entire groups of counterparties, such as perhaps the foreign institutions in our example. And they might even avoid them at any interest rate (a partial but perfect inelasticity).

They still have spare cash to lend, so they’ll compete with other dealers to lend the surplus only among a much smaller cohort. 

That means Domestic Bank A & B are offered even more cash, which they’ll likely take on given the crisis circumstances, while Foreign Bank A & B are left with nothing.

Overall, however, the same $120mm is sent into the hypothetical fed funds marketplace only on Day 3 the weighted average, EFF is now less than it was on either Day 2 or Day 1; less than the policy target. Because fed funds only takes into account the funding transactions that happened and ignores those that disappeared, when the weighted average declines it does so distorting and masking the clear distress behind that decline.

What’s important in this case isn’t what happened but what didn’t. The rate signals monetary excess and that’s true but for only a part of the overall system. 

While the numbers are simplified and the example merely a stylized one, this is, in fact, what did take place during the early days of GFC1 (as well as at crucial points throughout the rest of it). Fed funds like LIBOR shot up on August 9, 2007, just like Day2, and then on August 10, the results were an extreme form of Day 3.

EFF therefore “benefited” from counterparty shunning as well as the dumping of spare liquidity (in this one market as well as among a narrowed group of acceptable borrowers) at the expense of the rest of the system. Whereas LIBOR jumped – and remained high – because banks were being more accurate when asked at what rates they would lend if they had to; even if they weren’t actually lending on that day.

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Disclosure: This material has been distributed for informational purposes only. It is the opinion of the author and should not be considered as investment advice or a recommendation of any ...

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Moon Kil Woong 2 months ago Contributor's comment

Very true, banks are not interested in lending unless you are willing to pay credit card rates. This has been true for quite some time and is why banks sell your home loan as fast as they can to Fannie Mae, Freddie Mac, or anyone who will take it as fast as they can. The risk is not adequate to the rate and is why lowering rates that are already low don't help much in creating more monetary expansion.

Actually, if the Federal reserve found a way to force down credit card rates it may encourage more spending on the lower end of the income bracket because its clear that the upper end of the income bracket isn't affected much at all to borrow anymore.

Terrence Howard 2 months ago Member's comment

That's a good point I hadn't though of.