Effective Fed funds, rangebound but worth watching

The effective Fed funds rate has been inching up since November like many other short rates, but it is  still in the middle of the Fed target range and lower than a year ago. The IOER  (interest on excess reserves) rate that has been set for required and excess reserves by the Fed is at 25 bps, so there is little reason for bank lending in reserves outside the Fed. 

The main players (lenders) in Fed funds will be those not eligible for IOER, Federal Home Loan Banks (FHLB) and other GSEs. The majority of these Fed funds traders are the FHLBs at about 75% of trading volume. Trading volume in Fed funds has fallen from about $200 billion per day pre-crisis to current trading of only $60 billion per day.  FHLBs will lend at less than the IOR rather than hold funds at the Fed for no return. However, even this limited Fed funds market competes against the Fed's reverse repo (RRP) program.

The excess reserves of depository institutions have declined significantly this fall. This decline will be the largest sustained fall in excess reserves over the last five years. While this is not enough to force Fed funds to the high-end of the range, it does tell us that there is change in the supply of excess reserves that will start to play-out in the first quarter of 2015. 

The more dynamic behavior of short rates in 2015 will be the big story of the new year. The start of any rate increase is still up in the air and not set for the middle of the year regardless of market expectations and forecasts.