Fed Puzzles Over How to Best Keep Control of Interest Rates

(Bloomberg) -- The effects of the Federal Reserve’s balance-sheet runoff are beginning to weigh heavily on the minds of policy makers.

The minutes from the central bank’s Dec. 18-19 meeting released Wednesday were full of references to the Fed’s long-run framework for monetary-policy implementation. That includes the optimal level of reserves needed to maintain control over short-term interest rates -- and specifically the effective fed funds rate -- which has been drifting toward the upper end of the central bank’s target policy band for much of the past year.

Fed Puzzles Over How to Best Keep Control of Interest Rates

“They’re grappling with shrinking reserves and how that’s moving things and what they need to do to control the extent of these movements,” said Peter Boockvar, chief investment officer at Bleakley Financial Group. “It’s play-it-by-ear monetary policy.”

Here’s a snapshot of what participants discussed:

  • Fed funds rate: Staff noted the benchmark could begin to rise above the interest on excess reserves rate, or IOER, as reserves in the banking system decline. While staff noted that the uptick could be gradual, they acknowledged fed funds and other money-market rates could become somewhat volatile amid the adjustment to lower reserve balances.
  • Maintaining control: While the Fed has adjusted IOER twice to keep the fed funds rate within its target range, participants discussed other options for controlling of interest rates should upward pressures continue. Discussions touched on further IOER tweak and the use of the discount window, although there was recognition that such options have limitations. There was also some talk about slowing the pace of the decline in reserves.
  • New tools: Some participants expressed an interest in learning more about possible options for new ceiling tools to provide firmer control of the fed funds rate.

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