United States authorities have employed three principal policy instruments since the outbreak of global financial turmoil last year: 1) fiscal and monetary policy to stimulate the real economy; 2) temporary or permanent purchases of assets to liquefy financial markets; 3) direct financial support to address the solvency problems of individual institutions judged to be too complex to fail. Each instrument influences the three principal targets: economic recession, market illiquidity, and institutional insolvency.
The newly enacted Troubled Asset Recovery Program (TARP), the principal feature of the Emergency Economic Stabilization Act signed into law last week, has not dispelled doubts about whether that mammoth asset purchasing effort will be sufficient to put the US and global economy on the path to recovery. As a result, US policymakers appropriately are returning to their playbooks to see what more can be done.
For example, a further reduction in the federal funds rate is widely expected at the next meeting of the Federal Open Market Committee (FOMC) on October 28 and more likely before that date. The federal funds rate has already been reduced by 325 basis points from 5.25 percent before the outbreak of the crisis to 2.00 percent on April 30 of this year.
But the problem is that the FOMC's aggressive easing on monetary policy has not been entirely passed through to the London Interbank Offered Rates (LIBOR) in US dollars. LIBOR is an average of the interest rates that banks in London offer funds, in this case in US dollars, at various maturities to other banks. It is used as the basis for pricing loans and other forms of credit to public and private sector borrowers not only in London but also in the United States and around the world.
The figure shows that during the 12-month pre-crisis period of July 2006 to June 2007, the spread between 3-month dollar LIBOR and the Overnight Indexed Swap (OIS) rate based on the expected federal funds rate averaged a mere 9 basis points. Between July 2007 and September 2008 the spread soared upward to an average of 80 basis points (bps); it was 133 bps at the end of September. On October 3, 2008, 3-month LIBOR was 4.33 percent, only 100 basis points below the rate at the end of June 2007, and the LIBOR-OIS spread has increased to more than 250 bps. This higher spread is a clear indication that credit conditions have eased much less than the FOMC hoped.
Figure 3-month LIBOR-OIS spread
Note: The figure depicts end-of-month spreads between 3-month dollar LIBOR and the OIS rate.
To address more directly the pricing of dollar credit, the FOMC should temporarily shift its target from the overnight federal funds rate to the 3-month dollar LIBOR rate. If its notional target for the federal funds rate remains at 2.00 percent, the FOMC should target LIBOR at 2.09 percent. (A useful byproduct would be to loosen up the calibration of Federal Reserve policy from increments of 25 basis points.) If the FOMC were to reduce its notional federal funds target to 1.50 percent, the actual target of policy should be expressed as a 3-month LIBOR of 1.59 percent.
The desk of the Federal Reserve Bank of New York (FRBNY) would implement this policy by aggressively providing reserves to financial institutions using the full range of its expanded facilities to provide liquidity to the market, including traditional repurchase agreements (repo). It would continue to provide reserves until 3-month LIBOR reached the FOMC's newly expressed target. The actual federal funds rate will decline toward zero. By this conventional standard, financial markets would be flooded with dollar liquidity as financial institutions built up their reserves at their Federal Reserve Banks.1 The price of dollar credit should decline commensurately. This is what the FOMC has been trying to do since it first started lowering the federal funds rate in September 2007. The problem is that the funds rate has been disconnected from LIBOR and the price of credit in the economy.
Some members of the FOMC and other observers are concerned about a rise in inflation. This is now very unlikely in the face of a global recession of greater depth than any since the worst post World War II downturn in the early 1980s. However, they should be reassured that, as a by-product of this new operating procedure, as lending conditions in financial markets returned to normal, the federal funds rate would rise back toward its notional target.
Some members of the FOMC may have concerns about targeting what is essentially a private sector interest rate and one that some think is manipulated by the banks submitting information to the British Bankers' Association, which announces LIBOR in US dollars and other currencies each day. The concern is that banks might "game" the rate setting. That is a possible concern. But with sufficient funds provided by the Federal Reserve to the interbank market under the procedure outlined here, one can reasonably expect that competitive forces would minimize that risk.
Does any major central bank follow such a policy approach? Yes, the Swiss National Bank (SNB) expresses its policy as the midpoint of a target range for 3-month Swiss franc LIBOR and seeks to achieve that target primarily via interventions in the market for one-week Swiss franc repurchase agreements (repos). During the crisis period, the SNB has generally been able to achieve its LIBOR target, which since late September 2007 has been a mid-point of 2.75 percent within a range of 2.25 and 3.25 percent, even as the index for the overnight repo rate has dropped to 1.58 percent from about 2.25 percent a year ago.
As with other measures to address the global financial crisis, implementing my proposal is not a silver bullet. But it deserves consideration as a device to reduce the price of dollar credit to ordinary borrowers. In the process, financial markets would be liquefied and the number of financial institutions facing insolvency would be reduced.
1. With the passage of the TARP, the Federal Reserve can now pay interest on these reserves. The Federal Reserve Board announced on October 6 that the interest rate would be 75 basis points below the federal funds rate. It is likely that to make my proposal operational the interest rate paid on reserves would have to be reduced further. Otherwise, the interest rate on reserves will limit banks' willingness to lower the rate at which they offer funds to other banks—LIBOR.