Powell Seeks to Regain Control Over Fed Funds With IOER Tweak

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The Federal Reserve on Wednesday made an adjustment to its tools used to control key benchmark rate in conjunction with its decision to ease overall policy.

Fed officials decided to lower the interest paid on excess reserves by 30 basis points to 1.8%, effective Sept. 19, while lowering its target range by 25 basis points to 1.75% to 2%. It also lowered the rate on its overnight facility for reverse repurchase agreements by 30 basis points to 1.70%.

The central bank’s shift follows three days of volatility in the market for repurchase agreements. The spike in overnight repo pulled the Fed’s benchmark rate above the current range and forced the central bank to conduct first-in-a-decade operations to quell the surge in short-term rates.

Chairman Jerome Powell said in his press conference the operations were effective in relieving funding pressures, and expects the fed funds rate to move back into the target range. Powell also said the central bank plans to conduct operations as necessary and will over time, provide a “sufficient supply of reserves” so frequent operations aren’t required.

Whether the latest tweak from the Fed is effective in curbing pressure on the fed funds rate remains to be seen.

Key Insights

  • Lowering the interest on excess reserves (IOER) rate could put downward pressure on the fed funds rate by further reducing the incentive for banks to park money at the central bank and instead lend in other short-term markets, such as fed funds.
  • A week ago, an IOER adjustment wasn’t part of expectations for the September meeting. Interest rate strategists shifted their outlook once the fed funds rate moved in line -- and then above -- the Fed’s target range.
  • This is the fourth time in the past year that the Fed has increased the gap between IOER and the top of the central bank’s target range, which is now 20 basis points.
  • This latest adjustment echoes actions it took in June and December 2018, and then in May, to keep in check the buoyant effective fed funds rate, although this is the first time that the Fed has shifted IOER while lowering rates.
  • In June and December 2018 the tweaks took place in conjunction with increase 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. In May, the Fed lowered IOER by 5 basis points while keeping its benchmark rate unchanged.
  • In addition to lowering IOER, strategists including Bank of America’s Mark Cabana and Goldman Sachs’s Praveen Korapaty, and Morgan Stanley‘s Matthew Hornbach believe the Fed could resume purchasing assets to replenish and stabilize reserves
  • “The only way to fix this underlying issue is for the Fed to grow the balance sheet (to prevent the decline in reserves) or set up a proper Standing Repo Facility (SRF),” TD strategists led by Priya Misra say in note. “We don’t think that the Fed is ready to do either just yet, and we expect more overnight repo operations based on market conditions”
  • Powell said the Fed took appropriate actions on this week’s funding pressures, adding that they have the tools, and will use as needed. In regards to balance sheet expansion, the chairman said the Fed will revisit the question of when to grow the balance sheet, though it may be earlier than thought.

Market Action

  • Treasuries pared gains after the Fed tweak. The 10-year yield is lower by 3.7 basis points to 1.77%. Futures traders still see about another quarter-point of easing, with the implied rate on January 2020 fed funds futures at 1.63%

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