[lbo-talk] Krugman on interest rate weirdness

[Michael Pollak]

[From his blog]

http://krugman.blogs.nytimes.com/2008/03/20/fed-funds-question-seriously-wonkish-and-possibly-dumb-too/

March 20, 2008, 5:14 pm

Fed funds question (seriously wonkish, and possibly dumb too)

The target Fed funds rate is now 2.25%. Everyone expects it to be reduced 
further; Citi economists predict that it will be down to 1% by mid-year.

But I have a possibly naive question: can the Fed really cut the Fed funds 
rate that far? I don't mean "can" in the sense that other concerns will 
give them pause; I mean literally -- does the Fed really have that 
ability?

Bear with me while I talk this through. The Fed actually conducts monetary 
policy through open-market operations in Treasuries: the FOMC tells the 
open-market desk to buy or sell Treasuries from banks until the Fed funds 
rate is close to the target. Normally this puts Treasury interest rates 
close to the Fed funds rate, since one short-term loan to a very safe 
customer is a lot like another.

But right now Treasury interest rates are much, much lower than the Fed 
funds rate -- around half a percent on both 1-month and 3-month bills. 
Weirdness like negative rates on repos aside (I'm still trying to wrap my 
mind around that one), basically the Fed can only drive Treasury rates 
down by about another half-point -- which would still seem to leave Fed 
funds well above 1%.

How is it possible for the Fed funds rate to be higher than the Treasury 
rates? Well, one interpretation is that banks don't trust each other -- 
not even for overnight loans. Fed fund loans, after all, are unsecured.

In other words, the Fed funds rate may be more like LIBOR than the 
Treasury rate -- and it may be being held up by a premium similar to the 
TED spread.

Am I being really stupid here? Or is it possible that the fear factor will 
soon make it impossible for the Fed even to achieve its target on the 
interest rate it supposedly controls?