Fed’s fight for con­trol of its key in­ter­est rate

Gulf Times Business - - BUSINESS - By Alexan­dra Har­ris

If a ship cross­ing a wide and placid har­bour yaws so far that it al­most hits the chan­nel mark­ers, its cap­tain might want to have the rud­der ad­justed. That’s what the Fed­eral Re­serve is at­tempt­ing to do as the fed funds rate inches closer to the top of the cen­tral bank’s tar­get range. Yet even af­ter an un­prece­dented change to one of its key pol­i­cy­set­ting tools in June, the gap be­tween the fed funds rate and the up­per bound of the range con­tin­ues to nar­row, and is once again at its small­est in al­most eight years. That po­ten­tially sets the stage for fur­ther ad­just­ments in the months ahead as pol­i­cy­mak­ers look to tighten con­trol over what is ar­guably the most im­por­tant in­ter­est rate in the world.

1. What’s go­ing on?

In De­cem­ber 2015, the Fed re­sponded to im­prov­ing eco­nomic con­di­tions by rais­ing in­ter­est rates that it had cut to near zero dur­ing the fi­nan­cial cri­sis. It set a tar­get range for the fed funds rate of 0.25% to 0.5%. Since then it’s in­creased the range an­other seven times, to 2% to 2.25% cur­rently. For most of that time, the ef­fec­tive fed funds rate – the av­er­age of what bor­row­ers in the mar­ket ac­tu­ally paid – rested com­fort­ably near the range’s mid­point, just like it’s sup­posed to. But since the be­gin­ning of the year, fed funds has been creep­ing higher, now sit­ting just five ba­sis points be­low the top of the range, at 2.20%.

2. What is the fed funds rate?

It’s the rate at which big banks make overnight loans to each other from the re­serves they keep on de­posit at the Fed. Be­cause it’s the ba­sis for ev­ery­thing from credit card and auto loan rates to cer­tifi­cate of de­posit yields, of­fi­cials use a range of pol­icy tools to ex­ert con­trol over it and thereby in­flu­ence the di­rec­tion of the broader econ­omy.

3. How does that work?

Dif­fer­ently than it tra­di­tion­ally did. Be­fore 2008, the Fed used a play­book based on the fact that those re­serves were in short sup­ply. If pol­icy mak­ers wanted the fed funds rate to fall, the New York Fed’s Open Mar­kets desk would buy gov­ern­ment se­cu­ri­ties from de­pos­i­tory in­sti­tu­tions. That in­creased their re­serves, mean­ing they had more to loan out, which in turn meant lower rates. If it wanted the rate to rise, the desk would sell se­cu­ri­ties, drain­ing re­serves and prompt­ing banks to charge more to lend out what they had left.

4. What about now?

In re­sponse to the fi­nan­cial cri­sis, along with cut­ting rates, the Fed bought tril­lions of dol­lars of bonds in a pro­gram known as quan­ti­ta­tive eas­ing. It paid for the bonds by cre­at­ing vast new bank re­serves. With all that money on hand, banks had far less need to bor­row from each other overnight, mean­ing that the Fed’s old tools of ad­ding to or re­duc­ing re­serves had less im­pact, forc­ing mone­tary au­thor­i­ties to come up with an­other way to in­flu­ence the ef­fec­tive rate. En­ter the in­ter­est on ex­cess re­serves (IOER) rate.

5. What’s the IOER?

Start­ing in 2008, Congress al­lowed the Fed to pay banks for the sur­plus cash they store at the cen­tral bank. As Fed of­fi­cials pre­pared for “lift off,” they re­alised that IOER could be a use­ful tool for manag­ing rates. In the­ory, if the fed funds rate were to climb above the IOER rate, firms would with­draw re­serves and lend them to other fi­nan­cial in­sti­tu­tions at that higher rate. But that in­crease in the sup­ply of re­serves avail­able for loans would then push the Fed funds rate back down to the IOER level. They cre­ated an­other mech­a­nism, called the overnight re­v­erse re­pur­chase agree­ment fa­cil­ity, to act as an in­ter­est-rate floor.

6. Why is the fed funds rate ris­ing to­ward the top of the band?

No one is 100% sure. But a pre­vail­ing the­ory, one sup­ported by Fed of­fi­cials in min­utes of their Septem­ber pol­icy meeting, is that el­e­vated Trea­sury-bill sup­ply - and a cor­re­spond­ing in­crease in yields - is con­tribut­ing to the bench­mark’s rise. That has pushed other key overnight rates higher, es­pe­cially in the mar­ket for re­pur­chase agree­ments. As these other short-term as­sets be­came more at­trac­tive al­ter­na­tives to lend­ing re­serves to other banks, the avail­abil­ity of fund­ing has less­ened, putting up­ward pres­sure on the ef­fec­tive fed funds rate. Some strate­gists also be­lieve that the cen­tral bank’s bal­ance-sheet un­wind is also start­ing to have an im­pact.

7. Didn’t the Fed al­ready make an ad­just­ment?

Yes. At their June 12-13 meeting, of­fi­cials low­ered the rate they pay on ex­cess re­serves rel­a­tive to the up­per bound of the tar­get range by 5 ba­sis points. They did this by boost­ing their tar­get range by 25 ba­sis points while in­creas­ing the in­ter­est on ex­cess re­serves rate by only 20 ba­sis points, to 1.95%. But given that the fed funds rate keeps edg­ing higher, Wall Street is wa­ger­ing they’ll be forced to act again. In fact, trading in fed funds fu­tures sug­gests mar­kets now see an­other ad­just­ment as all but as­sured by year-end.

8. Will it work this time?

The Fed would seem to think so. At his Septem­ber post-meeting press con­fer­ence, chair­man Jerome Pow­ell said the ris­ing fed ef­fec­tive rate is “a prob­lem we can ad­dress with our tools, and we’ll use them if we have to.” Oth­ers, such as Credit Su­isse Group AG an­a­lyst and for­mer US Trea­sury ad­viser Zoltan Pozsar, aren’t so sure. He sees the ad­just­ments as a short-term so­lu­tion to a longer-term prob­lem that could even­tu­ally re­quire changes to the Fed’s op­er­at­ing frame­work.

9. Can they just keep low­er­ing the IOER rate in­def­i­nitely?

Al­most cer­tainly not. Should the Fed make an­other ad­just­ment this year, it would put the gap be­tween IOER and the rate on the Fed’s overnight re­v­erse repo fa­cil­ity at 15 ba­sis points. Fur­ther tight­en­ing in the IOER spread rel­a­tive to the RRP rate could cre­ate “ex­treme stress” for banks in terms of liq­uid­ity, ac­cord­ing to Michael Clo­herty, the head of US in­ter­e­strate strat­egy at RBC Cap­i­tal Mar­kets. Of­fi­cials may only be able to tweak the IOER rate two more times – in­clud­ing a De­cem­ber ad­just­ment – ac­cord­ing to strate­gists at Bank of Amer­ica Corp.

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