E-Letter to Dr. Irwin Kellner and CBS.Marketwatch.com Re: The Federal Funds Rate

Your recent column, "Wall St. Two-Step: Stocks and Bonds" does a good job of succinctly describing the tensions and even anxiety that exists among investors who have one eye on earnings reports and the other on Federal Reserve policy. However, I think that in your analysis there is a mistaken assumption. That being your belief that lower interest rates have the potential to "cushion the economy's slide, keeping profits from falling into a hole", as you put it. Your analysis fails to address the fact that it really is not lower interest rates, per se, that the markets are looking for, but rather, increased liquidity. The two are not the same.

A reduction of the federal funds rate does not mean that liquidity has been increased in the marketplace. In fact, liquidity can actually be reduced when the federal funds rate is lowered.

Contrary to popular relief, the Federal Reserve does not directly control the federal funds rate. It does not participate in any way in the federal funds market. The federal funds rate reflects nothing more than a daily market, between banks, for cash reserves. The federal funds rate is determined, in the course of a market day, by the supply and demand for cash reserves between commercial banks.

The connection between the Fed and the federal funds rate is through the repurchase agreement rate (repo rate), which the federal funds rate closely follows, and which the Fed influences through its daily transactions in the repo markets. Normally, changes in the repo rate are reflected in the federal funds rate and therefore the Fed is able to influence the federal funds rate via its influence over the repo rate.

But it is a substantive as well as a technical mistake to accept the popular notion that the Federal Reserve directly and arbitrarily sets the Federal Funds rate - as if by decree.

This is important to understand because the repo market transactions utilized by the Fed to influence the federal funds rate do not necessarily result in increased liquidity, not just for the entire marketplace but also for the member banks that bid for federal funds. And in fact the Fed can actually alter the bidding behavior of member banks simply by doing what it has over the last month - communicate a bias for lower rates.

A clear description of how this works is provided by international economist, Michael Darda, of Polyconomics Inc. who explains,

"If the (Federal Reserve Banks) FRBs expect lower rates, bidding activity at the current fed funds rate can stall, forcing the Fed to retrieve liquidity in order to hold the fed funds target in place. Conversely, if the FRBs expect rising rates, circa 1993-94, the Fed can end up in a situation in which the Banks bid for more reserves even as rates rise, forcing the Fed to monetize debt to hold the higher target in place… Between 1990 and 1999, the BoJ's target rate on overnight funds fell from 9% to zero but the expectation of continuously falling rates, and prices, caused banks' bidding activity to stall -- forcing the Bank of Japan to REDUCE the monetary base even as it cut rates"

This "reverse treadmill" effect has been in evidence since the Fed announced its decision regarding the federal funds rate on January 3. The market immediately realized that next to no liquidity was being produced as a result of targeting the federal funds rate and therefore was unable to sustain the early gains made immediately after the Fed's announcement.

The crux of the problem, which your commentary reveals, is that there are different opinions of what "easing" means.

There are those, such as yourself, and most Keynesian economists who believe that easing occurs when interest rates are cut by a certain percentage. And then there are the monetarists who believe that easing occurs when the monetary base grows by a certain amount.

But how do you, the Keynesians and Monetarists explain the scenario when interest rates and the monetary base are simultaneously rising or when both are simultaneously falling? Is monetary policy really being eased when interest rates are falling and liquidity is disappearing from the marketplace? This is what happened in the time period of 1990 to 1991.

This contradiction causes others such as myself to believe that "easing" really only occurs when the Fed has purchased enough bonds in the open market to raise the price of gold, the most monetary of all commodities, to a certain level.

I accept 1999 Nobel Prize Economist Robert Mundell's belief that it would be sufficient if the Federal Reserve would inject liquidity into the financial system until the price of gold rose to $310. In order to ensure that the financial markets are "liquid" enough especially in light of the recent earnings woes and layoffs of numerous companies, the Federal Reserve should not target the price of credit, through the federal funds rate, but rather, the price of money, through the price of gold - the purchasing power of the dollar relative to gold.

The price of gold is a superior indicator of market liquidity than interest rates or money supply measures.

Dr. Kellner your concise column has properly identified the current tension in the market place between earnings reports, Federal Reserve policy, and expectations in the equity and bond markets but your definition of "ease" causes you to misunderstand the impact of Federal Reserve policy on the psyche of the investment community.

Only an injection of high-powered money, aimed at a monetary target that reveals the supply and demand for money can alleviate the market's liquidity concerns. If the Fed were to embrace such a strategy we believe that investors would be in the best possible position in which to deal with the news of poor earnings reports and layoffs.

Cutting the federal funds rate simply cannot accomplish this goal.


Cedric Muhammad

Wednesday, February 7, 2001