This weekend I have a little bit of provocative – and counterintuitive – Fed wisdom for you.
The Fed does not control rates. The supply of and demand for short term paper drives rates. The Fed just rubber stamps what the market has already done.
Read that again: The Fed has no control over rates.
The market tightens all on its own – and that’s just what it’s doing now.
Now, back in the good old days before QE, the Fed did control rates, because it kept reserves in the banking system to a bare minimum. That way it could add or withdraw a little cash from the system on a daily basis to keep the Fed Funds rate near its target.
The Fed Funds rate is the interest rate that banks charge each other to borrow reserves overnight. Banks that were short of reserves borrowed, and banks that had a little extra, lent the funds.
If the Fed Funds rate was trading above target, the Fed would add just enough cash to the market to cause the rate to fall back into the target band. If Fed Funds were trading below target, the Fed would likewise pull a little money out of the system. Keeping reserves generally tight allowed the Fed to manipulate the market toward its target.
But in today’s world, with still a couple trillion of excess reserves in the system, the Fed can’t do that. The vast majority of banks have plenty of reserves and don’t need to borrow Fed Funds to meet their minimum reserve requirement.