USA TODAY International Edition
Question isn’t when, but CAN Fed raise rates
A banking system awash in Fed cash could make hiking rates trickier — and deploy risky, less precise strategies
Fed must use new, riskier tactic to lift rates.
Federal Reserve Chief Janet Yellen last week said she expects to raise interest rates in 2015 after seven years of unprecedented easy money helped the economy shake the financial crisis. And so the question for the central bank is likely to soon move from when it will boost its benchmark rate to: Can it?
Because of the massive amount of cash sloshing around the banking system, the Fed will have to employ new, riskier tactics to gradually lift borrowing costs, strategies that make sense but are less precise, especially if there’s a scare in the markets.
“Nobody’s ever done this before,” says Jon Faust, director of the Center for Financial Economics for Johns Hopkins University and special adviser to the Fed’s board of governors until last September.
The Fed’s capacity to bump up rates is critical to retaining the confidence of financial markets and heading off a potential- ly sharp rise in inflation as the economy heats up.
The Fed’s policymaking committee “is confident that it has the tools it needs to raise shortterm interest rates when it becomes appropriate to do so,” Yellen said earlier this year.
Faust agrees, but adds that those tools, “will almost certainly be less precise” than they were before the financial crisis.
Back then, the Fed easily controlled its benchmark federal funds rate, which is what banks charge each other for overnight loans to meet daily cash- flow needs. To lower the rate, the Fed bought securities from banks or brokers, increasing cash reserves in the banking system and pushing down the cost to borrow the money. To raise the rate, the Fed sold securities, shrinking those cash reserves.
The fed funds rate thus
“Nobody’s ever done this before.” Jon Faust, director of the Center for Financial Economics for Johns Hopkins University
served as a reliable benchmark and had a domino effect on interest rates across the economy, from mortgages to corporate bonds.
But since the Fed bought massive quantities of Treasury and mortgage bonds after the crisis to stimulate a wobbly economy, banks have $ 2.5 trillion in excess reserves, up from about $ 2 billion pre- crisis. As a result, the Fed can no longer impact the fed funds rate with relatively small securities purchases.
Instead, it has set the funds rate since 2008 by paying banks 0.25% in interest to park their excess reserves at the Fed overnight. No bank should lend money at a rate below a risk- free deposit at the Fed.
Other entities flush with cash, such as federal home loan banks and money- market mutual funds, can’t earn interest from the Fed and so they sometimes lend to banks at a lower rate. The fed funds rate, in turn, has hovered between zero and 0.25%.
That means that to raise rates, the Fed must give mutual funds and others a similar way to earn interest. Since 2013, the Fed has tested overnight reverse repurchase agreements. A money market fund, for example, can purchase a risk- free security from the Fed for one day at up to 0.05% interest, discouraging it from lending to a bank at a lower rate.
As the Fed pushes up rates, it will announce a target range for the funds rate, probably 0.25% to 0.5% initially. The reverse repo rate will serve as the floor for that range, and the excess- reserve rate for banks, the ceiling.
Here’s the problem: The Fed has set a $ 300 billion daily limit on such reverse repos because it’s worried that during times of financial turmoil, hedge funds and other investors could flock to the safe, fixed- rate investment, curtailing lending activity and worsening any crisis.
A limit on reverse repos, however, means that some financial firms may not have access to the facility at times, spurring them to lend money to banks at a lower rate that undercuts the Fed’s target range. That risk is especially acute at the end of quarters, when many firms crave liquid assets.
Fed officials have tried to ease the concerns. As rate increases begin, the Fed plans to temporarily increase the $ 300 billion limit. And at quarter- ends, it plans to offer another $ 300 billion in “term reverse repos” of several days to soak up the extra demand.
Still, “there is a risk that if you put too many restrictions ( on reverse repos), it may not act as an effective floor ( for interest rates),” says Lewis Alexander, chief U. S. economist of Nomura.
Another risk is that, as rates edge higher, other cash- rich enti- ties that can’t invest in reverse repos will scamble to lend money at rates below the Fed’s target but higher than the next- to- nothing they’re now earning. Such enti- ties could include insurance companies and pension funds.
As a result, the fed funds rate could occasionally dip below the Fed’s target. If that happens persistently, “I do think it could be potentially unsettling” to markets, Alexander says.
Ironically, that could push up Treasury yields and other market rates prematurely as investors fear the central bank will eventually have to bump up rates more rapidly to catch up.
Fed policymakers have said they have other tools to raise rates, including offering longerterm deposits to banks, raising the rate on excess reserves and selling bonds.
All would absorb cash from the financial system and push up the Fed’s key rate.
“I think they’ve given them- selves sufficient flexibility,” says Tim Duy, a University of Oregon economics professor and author of the Fedwatch blog.
And Faust says a funds rate that periodically falls below the Fed’s target likely won’t be worrisome as long as lenders and financial markets understand the central bank’s intended path for the rate over the longer term.
The Fed’s biggest challenge, he says, will come during periods of financial stress, when fears of an economic downturn could drive the funds rate further below the Fed’s target.
“That could make people even more worried and have more erratic effects,” Faust says. “There will be particular demands on ( the Fed)” to communicate, for example, that the drop “doesn’t reflect a ( policy) change.”
“There is a risk that if you put too many restrictions ( on reverse repos), it may not act as an effective floor ( for interest rates).” Lewis Alexander, chief U. S. economist of Nomura