Fed Funds: What's Next?

For the past 15 months, Fed Funds Effective rates closed between 0.07 - 0.10 with 0.09 the popular close price in 9 of the past 15 months and 5 of the past 6 months. To understand the context regarding what historical low prices mean, history is the guide. July and October 1954 saw 0..63 and 0.75 prices. Then February and May 1958 experienced rates of 0.73 and 0.20. June and July 1958 again saw lows at 0.61 and 0.36. February - July 1958 was the only period in 60 years where Fed Funds Effective rates traded so low for so long and on a close basis. When the Housing crisis was announced August 2008, Fed Funds closed at 1.99 then September 2008 at 1.54 and October 2008 at 0.82. October 2008 then began the 6 year downslide that has seen rates low for long at the bottoms.

Why rates never reached zero or negative throughout the 6 year period is due to the fact that the Fed began to pay interest on excess reserves in 2008 as stimulus money was appropriated. It's been known since Keynes in the 1930s that interest rates drop as money is appropriated and spent at high levels since money and interest share an adversarial relationship. The job of central banks is to prevent rates from dropping to zero and worse, trade or close negatively as is the present scenario in Europe. To further control Fed Funds when Taper is formally rescinded, the Fed soon begins the Overnight Fixed Rate Reverse Repurchase Agreement Facility.

If the Fed can maintain Bid / Ask spreads within its mentioned 0 - 5 Basis point ranges on overnight funds and pay interest on any excesses, it ensures Fed Funds maintains again small trading channels. The ranges and rates rise as the Fed pays higher interest on ever diminishing excess reserves as Taper money decreases. Adjusting ranges higher and paying higher interest begins the actual process to normalization of rates once again and it will be seen in the Overnight Reverse Repurchase Agreement facility. China traditionally adjust its Reserve Requirement figure to steer reserves and the Fed is no different. Normalization by Fed standards begins in the banking system as is the same case for China through Reserve Requirements.

The Fed Minutes reveal 16 governors forsee Fed Funds at or below 0.1248 for all 2014. The point at 0.1248 is actually the shorter term average and the rate to beat to maintain a higher Fed Funds Effective rate. The range on that average is found between 0.09 and 0.005 at extremes. The point at 0.005 is an actual rise from last month's low extreme at minus 0.0003 but the rise is evolutionary based on calculated numbers rather than a Fed Comment. To see a run higher towards 0.1248 faster, then 0.1113 must break higher. The break is not expected as the Tail Risk on both tails remains low at 26% which means an 83% probability exist Fed Funds maintains current ranges unless a shock hits the markets.

If 0.1248 breaks higher, ranges become 0.1248 - 1.6487, the next highest average and an average that rose since last month. Again context to understand what low for longer meant over 6 years. The ranges on the 1.6487 average are all deeeply negative from minus 1 - minus 2.0. The point at 0.60 must break to possibly give back a semblance of normalcy. The highest rate long term is found at 2.93.

Current Fed Funds CME contracts reveal Fed Funds at the April meeting at 0.12, May 0.74, June 0.17 and 0.24 July 2015. Rates then are seen rising progressively higher. The current range on the benchmark interest rate is 0 - 0.25, halfway point is found at 0.125 so at 0.124, Fed Funds Effective is slightly below.

But a rise based on the Fed Minutes occurs when Inflation hits the 2% target from the current 1-1/2%. High Inflation while rates remain at rock bottom lows and a far distance to 2% is the way of current monetary policy. The BOJ seeks 2% Inflation while interest rates remain ultra low, Australia's Cash Rate is currently 2.5% with 3.0% Inflation and at upper end of its target, Canada's interest rate at 1% accompanies core CPI at 2.1%. Only New Zealand took the lead and normalized rates to the point current OCR is above long term equilibrium rates and Inflation. New Zealand reversed the current trend. Only the BOE threatens to raise rates in the near future.

It's not that Fed Fund rates will rise, they must rise because averages and ranges are rising with each new month. The Fed is racing against time as the market may impose rate rises before the Fed is ready. The risks of course are Inflation rates that begin at highest levels before an actual increase. 2% is the chart line that dates to just prior to 2008. Any problems along the way then Inflation may rise higher and faster than anticipated. It's quite a balancing act that's underway.