Friday, March 21, 2008

An Offer They Can't Refuse

What options do we have for stimulating the economy once T-Bills rates hit zero? Traditionally, the Fed encourages bank lending by buying T-Bills.

The Federal government limints the amount of loans a bank can give out based on the amount of cash they have in the vault. So each day the bank has to decide to

A) Keep money in the vault and use it to support new loans to customers

B) Loan out the vault cash to other banks

C) Loan the vault cash to the Federal government by buying government bonds also known as T-Bills


To stimulate the economy the Federal reserve buys up T-Bills. This lowers the interest rate on T-Bills and encourages banks to try to lend more to each other. However, on net inter-bank lending must be zero. That is, every loan to one bank must be matched by borrowing by another bank.

When too many banks try to lend to each other at once the interest rate on interbank lending, the federal funds rate, falls. This leaves the banks with only one good option - lend more to customers. And that exactly what we want.

What happens, however, if the interest rate on T-Bills goes to zero. Then even if the Federal Reserve buys more T-Bills it doesn't encourage banks to lend more to each other. Thats because the Fed is not making T-Bills less attractive. Zero is still zero.

One question might be, "If the interest rate on T-Bills is zero but the Fed funds rate is not zero, then why would ever buy T-Bills."

The answer is that T-Bills are backed by the full faith and credit of the US government. When a bank loans to another bank it has the full faith and credit of that bank, but in this environment the banks don't have the same kind of credit they used to.

So what can the Fed do to get around this?

It can lend to the banks directly. Currently the Fed charges more to lend money to banks than banks charge each other. Thats because the Fed only wants lend as a last resort.

However, the Fed could change that and make borrowing from the Fed just as attractive as borrowing from other banks.

Some economists worry that banks will be hesitant to borrow from the Fed because typcially that is seen as a last resort and no bank wants to look desperate.

However, as the cost of borrowing from the Fed goes to zero and possibly even (gasp) below zero banks will change their minds. Indeed, they will probably all change their minds at once in what researchers think of as a tipping point.

The question is how do we manage that tipping point. One way is to make the loans a temporary feature. The Fed can allow temporary loans for up to 28 days and less than say $50 billion at this super low rate. Then it can judge participation and if necessary offer new loans when the 28 days is up.

If these rates are low enough banks will find them irresistible. Its possible that for short periods the Fed could even loan out money at negative rates. That means the Fed pays banks for taking out a loan. Thats an offer that few banks could refuse.

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