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Consequences of the Lehman Bankruptcy

Written by A Forex View From Afar on Tuesday, October 28, 2008

Since Lehman was declared bankrupt, it seems the financial world has gone completely mad. In the past few weeks the LIBOR rates have set new records, now the Fed funds rate is following.

However, what exactly is the “Fed funds rate”? The fund rate is the inter-banking rate at which U.S. primary dealers lend to each other to meet the minimum reserve requirements. In order for a bank to operate, it needs to build up a minimum reserve at the Federal Reserve. Due to diverse operations (lending, deposits) the minimum required figure changes from one day to the next. As such, banks that do not meet the minimum requirements borrow from those who have excess reserves.

When the Fed sets the interest rate, it actually sets the target for the Fed funds rate. It should be noted, that the Fed only targets a specific rate, but the real (effective) rate, fluctuates on a daily basis around the targeted rate.

Here is where the Fed’s problems come in. It looks like lately, especially after the Lehman collapse, that the Fed has lost control over the effective rate. A simple look over the attached chart can see the high volatility occurring in the Fed funds market. The yellow line shows the effective rate, while the straight line denotes the target rate. Notice how after the Lehman collapse, from the middle of September, the effective rate has gone haywire.

This is very important because it actually shows the loss of control over the Fed Funds, which through others, is the rate at which the central bank controls the whole economy and the business cycle. Losing the ability to control monetary policy, the central bank has practically tied its own hands.

With the effective rate staying at 0.95% (compared with the targeted rate of 1.5%) it looks like the Fed will only have to sign the paper on Wednesday, because the inter-banking market has already priced in a 50 basis point rate cut. The “cut joy” will be seen only in the stock market and for a limited amount of time.

Fed Funds Rate after Lehman

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