NCPA - National Center for Policy Analysis


September 12, 2008

Following the unexpected leap in interest rates on the overnight loans between banks in August 2007 and the subsequent turmoil in world money markets -- a so-called "black swan" event -- the Federal Reserve took several steps to stabilize the situation, says the National Bureau of Economic Research (NBER).

The Fed has made several attempts to improve conditions in money markets to reduce the spread between term inter-bank lending rates, such as the three-month Libor (London Inter-Bank Offer Rates), the Overnight Index Swap (OIS) and the Term Auction Facility (TAF), but to no avail.

The "black swan" is most notable from January 2007 to March 2008.  According to researchers:

  • Between January 2007 and August 2007, the standard deviation of difference between effective funds rate and the target was only three basis points, but from August 2007 to March 2008, the standard deviation was 20 basis points.
  • This suggests that the spreads between the three-month Libor and the Fed's overnight federal funds rate target increased dramatically starting in August and fluctuated erratically thereafter.
  • During the year prior to August 9, 2007, the three-month Libor spread above the target federal funds averaged only 11 basis points with a standard deviation of merely a single basis point.

Overall they found that there is no statistical relationship between the Libor-OIS interest rate spread and the utilization of the TAF.

However, this is not especially unexpected, say researchers.  Any increase in liquidity that comes from banks borrowing from the Fed using TAF will be offset by open market sales of securities by the Fed to keep the total supply of reserves from plummeting.  The actions are essentially automatic in the sense that the Fed must sell securities to keep the federal funds rate on target, say researchers.

Source: Matt Nesvisky, "A Black Swan In The Money Market," NBER Digest, August 2008; based upon: John B. Taylor and John C. Williams, "A Black Swan in the Money Market," National Bureau of Economic Research, Working Paper, No. 13943, April 2008.

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