The Marriner S. Eccles Federal Reserve building stands in Washington, D.C., U.S. (Photographer: Andrew Harrer/Bloomberg)

Battle for Control of the Fed's Main Target Looks Set to Rage On

(Bloomberg) -- The Federal Reserve is not only fighting to keep the U.S. economy on an even keel, but also to maintain control of the main interest rate it uses to do so. Whether its existing arsenal is up to the task remains to be seen.

The fed funds rate -- the central bank’s primary policy benchmark -- is approaching the upper end of the Fed’s targeted range. To try to nudge it lower, the central bank on Wednesday reduced something else: the interest on excess reserves rate, or IOER. Fed Chairman Jerome Powell, who described that move as a “small technical adjustment,” acknowledged that officials will examine whether to go a step further by creating another lever to help achieve their goals: a new kind of program for repurchase agreements.

“The whole IOER model was flawed to begin with,” Guggenheim Partners LLC’s Scott Minerd said in a Bloomberg Television interview. “It’s not as adequate to contain the funds rate and eventually the Fed will have to introduce a new policy tool.” He said that a repo tool would be the most straightforward way to go, but he wasn’t sure whether the Fed would take such an approach.

Battle for Control of the Fed's Main Target Looks Set to Rage On

The central bank tweaked IOER after the effective fed funds rate crept higher in recent weeks, fueled partly by a squeeze in other short-term funding markets. Fed funds has exceeded IOER for more than a month, and its rise this week to 2.45 percent prompted speculation that the Fed would tinker with things -- something that was borne out Wednesday with IOER being cut to 2.35 percent from 2.40 percent. The central bank wants the fed funds rate to stay below 2.50 percent and above 2.25 percent, a target range the Fed kept Wednesday.

The Third Tweak

Lowering IOER theoretically puts downward pressure on the fed funds rate. It does this by reducing the incentive for banks to park money at the central bank -- where they’re paid IOER -- and instead get better rates in other short-term markets, such as fed funds. Yet it has been an imperfect instrument, and fed funds has repeatedly risen above the rate that used to, in practical terms, act as a cap. Wednesday’s action is the third time in the past year that the Fed has increased the gap between IOER and the top of the central bank’s target range.

“The Fed controlling the fed funds rate is important,” Powell said at his press conference Wednesday. “I don’t see us not controlling it.”

This latest adjustment echoes actions the Fed took in June and December to keep in check the buoyant effective fed funds rate, although it’s the first time that the Fed has shifted IOER in the absence of a change to the main target range. On previous occasions, the tweaks took place in conjunction with increases to the main target range, with IOER rising by just 20 basis points each time and the main range being boosted by 25 basis points.

A New Tool?

There is still room for further shifts in IOER, but questions are increasingly being asked about whether a repo tool would be a more apt solution. The central bank itself has mentioned the idea at other Federal Open Market Committee meetings and the New York Fed has previously quizzed primary dealers whether it should consider something like this, according to people familiar with the discussions. The St. Louis Fed has published blog posts on the matter and Powell himself responded to a question on it Wednesday.

“We’ll be looking at the idea of a repo facility as a possible addition to our toolbox,” the Fed boss said. “It’s something we’ll do at an upcoming meeting, I imagine.”

Bank of Montreal strategists led by Ian Lyngen have estimated the odds of such a facility being rolled out by the end of next year are around 1-in-2.

“Powell demurred on his bias as to whether such a facility was warranted, and indicated that he has no obvious leaning either way,” they wrote in a note Wednesday.

Some observers say that ultimately the Fed may have to consider the idea of targeting another rate altogether instead of fed funds. Mark Cabana, head of U.S. interest-rate strategy at Bank of America Corp., said that fed funds no longer really reflects banks’ demand for funding and that officials appear to be “getting a little frustrated with some of the idiosyncrasies it contains.”

“The Fed is going to have to have a broader rethink about what the rate is that they’re targeting, why are they targeting that,” he said in an interview. “And these are some big decisions the Fed has coming down the pike for them.”

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