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Economic SYNOPSES
short essays and reports on the economic issues of the day
2007 ■ Number 23

Subprime Side Effects in the Federal Funds Market
Daniel L. Thornton
he recent turmoil in the subprime mortgage market has
reserves.1 The funds rate was below the target the next day,
despite a relatively smaller purchase of reserves. Moreover, the
had implications for the federal funds market. An apparent
funds rate remained below the target through the remainder of
flight to “safe” investments caused the federal funds rate
August. These facts suggest the possibility that the behavior of
to behave somewhat differently from what one might expect durthe funds rate is not particularly affected by daily OMOs.
ing a “liquidity crisis.” Specifically, in the wake of these developWhat did change in the wake of the developments in the subments, the rates on alternative sources of funds for depository
prime
mortgage market is a sharp rise in the short-term liquidity
institutions rose, while the federal funds rate dropped—falling
premium.
Specifically, the rates on short-term T-bills declined
and remaining below the FOMC’s target of 5.25 percent. The funds
significantly
relative to other short-term rates, apparently due to a
rate fell without any unusual open market operations (OMOs)
“flight
to
quality.
” The 4-week T-bill rate declined to 4.28 percent
or adjustment to the funds rate target.
on
August
10
and
declined further to a low of 2.35 percent on
The chart shows daily data since January 2007 of the effective
August
20
before
rising.
T-bills and federal funds are very good
federal funds rate, the FOMC’s funds rate target, and the 4-week
substitutes
for
meeting
the
liquidity needs of depository institusecondary market T-bill rate—as well as the New York Fed’s effections.
Hence,
one
possibility
is that the flight to quality pulled the
tive OMOs for the maintenance period (a 14-day period in which
funds
rate
down
from
the
FOMC’s
target. In contrast, rates on
bank reserves are measured). To measure the effect that OMOs
longer-term
sources
of
funding
for
depository institutions rose:
have on bank reserves and therefore the federal funds rate, I cal1-month
secondary-market
certificates
of deposit and 1-month
culate the OMO maintenance-period effect, which is the sum of
eurodollar
deposits
both
rose
about
25
basis
points on August 9 and
all securities purchased or sold by the New York Fed on a given
remained about 30 to 40 basis points above their pre-August 9
day, each of which are multiplied by their own maturity; the sum
levels through the end of the month. Rates that are not closely
is then divided by 14—the number of days in the reserve maintelinked to depository institutions’ liquidity or funding needs, such as
nance period. The resulting value indicates the cumulative effect
prime financial and nonfinancial commercial paper, were essentially
that one day’s OMOs has on bank reserves over the entire mainunaffected by developments in the subprime mortgage market. ■
tenance period.
1 However, this is the largest two-day injection of effective reserves for 2007, $10.5
Although the funds rate target was 5.25 percent on August 9,
billion. The next largest, $9.33 billion, was for the two days ending February 23.
the chart shows that the effective funds rate
was 5.41 percent, even though the Fed
increased the supply of reserves by purMaintenance-Period Effective Open Market Operations and
chasing $24 billion in assets on that day.
Selected Interest Rates
Because $12 billion of these transactions
5.50
40
had a 14-day maturity, while the other $12
35
billion had an overnight maturity, the
5.00
OMO maintenance-period effect of these
30
Maintenance-Period OMO
4.50
purchases was $12.86 billion. The next day,
Effective Funds Rate
25
4-Week T-Bill Rate
the Fed purchased $38 billion in assets,
4.00
20
FOMC’s Funds Rate Target
August 9, 2007
with an effect of $8.14 billion. The funds
15
3.50
rate averaged 4.68 percent, significantly
10
below the FOMC’s target. The chart shows
3.00
5
that, although these transactions are large,
2.50
they are not particularly unusual relative
0
to the size of OMOs made during the year.
2.00
–5
In sum, the funds rate was above the target
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on August 9, despite an apparent attempt
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1/
by the Fed to lower the rate by adding

T

Views expressed do not necessarily reflect official positions of the Federal Reserve System.

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