Supply-side economics reseach firm Laffer Associates has released a study entitled, "Rock Bottom, Fed Options in a Low Interest Rate Environment, written by Arthur Laffer and Kenneth Petersen. The white paper analyzes money market funds and examines Fed options in an ultra-low environment. It argues, "[T]he Fed will at most reduce the target Fed funds rate by another 25 basis points."
The introduction says, "Monetary policy is back to the level witnessed between mid 2003 and mid 2004, at 1%. This is the lowest target Fed funds rate ever recorded in the modern era of monetary policy, 1982 to the present, and you have to go back to 1958 to find a lower number in the all time historical record book. There is now talk about the Fed potentially lowering the target Fed funds rate all the way down to zero to entice skittish U.S. consumers to spend and firms to invest. Such a drastic move, however, would crush money market mutual funds as they would not be able to meet operating costs.
Laffer explains in a section entitled, "Pushing Money Market Mutual Funds Over the Edge, "Money market mutual funds generate returns by investing in high quality money market securities, mainly commercial paper (CP) and repos. Thus, the return on a typical money market mutual fund depends to a large degree on the returns on commercial paper and repos, which again are priced relative to the target Fed funds rate and the U.S. London Interbank Offered Rate (LIBOR). Yields on commercial paper have been greatly elevated relative to the target Fed funds rate during the last couple of months, but are currently heading south. A combination of buyers leaving the commercial paper market -- money market mutual funds faced massive redemptions and were forced to sell commercial paper -- and banks becoming reluctant to lend to each other, caused risk premiums associated with commercial paper and U.S. LIBOR to take off."
"The Fed's Commercial Paper Funding Facility (CPFF) and its Money Market Investor Funding Facility (MMIFF) programs defused the depression like risk premiums observed in the commercial paper market during September and most of October. Furthermore, the effect of the U.S. and Europe beginning to guarantee newly issued senior unsecured debt manifested itself in lower risk premiums in interbank markets around the globe, especially the London interbank market, which again very recently has reduced money market risk premiums," Laffer says.
The piece continues, "Historically the spreads between the target Fed funds rate and the yields on commercial paper, repos, and U.S. LIBOR have been fairly tight, and we, therefore, expect current money market yields to move closer to the target Fed funds rate. Falling yields on commercial paper will translate to lower yields on money market mutual funds.... The average annualized seven-day simple net yield on retail money funds in the U.S. is 1.26% on taxable money funds and 1.04% on tax exempt money funds. Going forward these yields will decline as the risk premiums in the commercial paper and the London interbank markets decline and converge to their historical means."
Laffer continues, "Money market experts, like Pete Crane from Cranedata.com, inform us that the spread between the target Fed funds rate and the average seven-day simple net yield during time periods when the target Fed funds rate remains constant, is approximately negative 25 basis points. Hence, a very low target Fed funds rate would cause a gigantic consolidation in the money market mutual fund industry, potentially destroying the industry."
They explain, "A target Fed funds rate of 0.75% would force a number of money market funds (especially Treasury-only money funds) to waive fees in order to avoid zero or negative yields. Almost all money market funds would be severely impacted should the target Fed funds rate drop to 0.5%, and the $3.6 trillion money market mutual fund industry would be virtually wiped out with a target Fed funds rate below 0.5%.... [A] devastated money market mutual fund industry would have grave ramifications for the commercial paper market. Firms would be forced to seek short term debt financing from banks, which charge more and currently operate with tight lending standards. Pushing the target Fed funds rate below 0.50% could, therefore, cause firms to face higher financing costs, not lower."
Finally, Laffer says, "Thus, it's unlikely that the Fed will go much below 1% and we believe that the Fed will at most do one last 25 basis point cut. This doesn't mean that the Fed has run out of ammunition and is incapable of influencing short-term economic activity. Several alternative policy strategies are available to the Fed, including printing money, swaying interest rate expectations, and targeting the yields on longer term Treasury (or private sector) securities." To request the full paper, e-mail pete@cranedata.us.
