Jerome Powell, chairman of the U.S. Federal Reserve, speaks during a news conference following a Federal Open Market Committee (FOMC) meeting in Washington, D.C., U.S. (Photographer: Andrew Harrer/Bloomberg)

The Fed Is Fighting for Control of Its Key Interest Rate

(Bloomberg) -- If a ship crossing a wide and placid harbor yaws so far that it almost hits the channel markers, its captain might want to have the rudder adjusted. That’s essentially what the Federal Reserve did twice in 2018. With the fed funds rate inching disconcertingly close to the top of the central bank’s target range, it chose to make unprecedented changes in June and December to one of its associated policy-setting tools: the interest on excess reserves rate. Now, following the latest tweak to IOER, as it’s known, market observers will be watching to see if the gap between fed funds and the upper bound of the central bank’s target range narrows again. That potentially sets the stage for further adjustments, although there are also questions around much more they can keep tinkering.

1. Why has the Fed been adjusting IOER?

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. Since then, it’s increased the range another eight times, to 2.25 percent to 2.50 percent 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 2018, fed funds has been creeping higher. Following the December adjustment to IOER it now sits around 10 basis points below the top of the range, but before the December Fed meeting it had shrunk to just five.

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, Fed 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 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 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 realized 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 begin lending reserves at that higher rate. But that increase in the supply of 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.

The Fed Is Fighting for Control of Its Key Interest Rate

6. Why has fed funds been rising toward the top of the band?

No one is 100 percent sure. But a prevailing theory, one supported by Fed officials in minutes of their September policy meeting, relates to the increase in borrowing by the U.S. government to fund its ballooning deficit. According to that theory, increased supply of Treasuries is putting upward pressure on yields across shorter-maturity instruments, 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 such funding has lessened, putting upward pressure on the effective fed funds rate. Some strategists also believe that the unwinding of the central bank’s balance-sheet is reducing support for money-market assets and having an impact.

7. The Fed’s already adjusted IOER, right?

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, and they made a similar move at their Dec. 18-19 gathering. On both occasions 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. But given that the fed funds rate continued to edge higher after the first tweak, there’s a chance they’ll be forced to act again.

8. Will this continue to work?

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 U.S. Treasury adviser Zoltan Pozsar, have expressed doubts. He has said such adjustments are 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. The Fed’s willingness to keep tweaking IOER could start to have major implications for everything from banks’ ability to meet their liquidity coverage ratios, to the signaling role of markets, to the future of the central bank’s policy-setting mechanism. Additional moves from here would bring IOER below the midpoint of the Fed’s target range, toward the critical overnight reverse-repo rate that now guides its floor, putting America’s monetary-policy framework to the test.

The Reference Shelf

  • A Bloomberg News story on the Fed’s decision to tinker with IOER for a second time.
  • Minutes of the November Fed meeting, at which officials discussed the possibility of tweaking IOER outside of Federal Open Market Committee gatherings.
  • Why the Treasury is being blamed for the Fed losing control of overnight rates.
  • A 2016 Federal Reserve Bank of St. Louis paper, "Interest Rate Control Is More Complicated Than You Thought."

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