by Ned Pagliarulo, analyst at Global Risk Insights
As the Federal Reserve continues to reduce the pace of asset purchases, attention has turned to the impending rise in interest rates. But to control short-term rates, the Fed will need to rely on new tools.
Ever since the Federal Reserve pushed interest rates down to effectively zero, the central bank has relied on large-scale asset purchases to boost the economy. Over the past months, the Fed incrementally reduced the pace of those purchases, from $85 to $35 billion in June. By this fall the Fed will likely no longer be adding to its balance sheet.
The question now becomes when and how short-term interest rates will rise when the Fed “normalizes” monetary policy away from a low rate environment. With the excess reserves held by banks hovering over $2.5 trillion, the federal funds rate may not function normally. In order to better control rates, the Fed looks set to utilize two new tools (among other smaller ones): interest on excess reserves and reverse repos.
Interest on Excess Reserves
Typically, when the Fed wants to change interest rates, it shifts its target for the federal funds rate. This rate represents what banks in the federal funds system charge each other for overnight loans. Banks are required to hold a certain amount of money in reserve with the Fed and borrow amongst each other to meet this threshold. When the Fed wants to change that overnight rate, it buys or sells securities to set total reserves at a level that pushes the rate up or down. The federal funds rate then acts as a benchmark for interest rates throughout the economy.
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With the level of reserves so high (prior to 2008, they were usually less than $30 billion), the Fed may no longer have its usual measure of control over rates. However, it was recently granted the authority to pay interest on excess reserves. In the view of Peter Gagnon, senior fellow at the Peterson Institute for International Economics, this “significantly affected the Fed’s ability to control interest rates.”
It works fairly simply. As the economy improves, banks would have an incentive to loan out those excess reserves. However, if they do so too fast, that could spark inflation. But with this new tool, the Fed can pay banks to leave their money essentially deposited at the Fed. In addition, because the money with the Fed is risk-free, this interest rate becomes a floor for other rates in the market. Banks would choose to keep money at the Fed until the rate of return on a loan exceeded that of the Fed’s offering.
Reverse Repos
However, interest on excess reserves works only with banks, who are in the federal funds system. Primary dealers, money market funds, and other financial institutions would not be as affected as banks. In response, the Fed has tested a tool know as overnight reverse repurchase (repo) agreements.
With reverse repos, the Fed offers to sell some of the securities it holds to financial institutions, agreeing to repurchase them with interest later on. This interest rate then becomes the reverse repo rate. Since the Fed is considered risk free, these institutions will prefer to “lend” their excess reserves to the Fed rather than to borrowers in the market – unless those market loans carry a higher rate of return than the reverse repo.
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Similar to how interest on excess reserves works for banks, this would help raise rates gradually. The Fed hopes to use this to control rates in the broader market as well as controlling the flow of excess reserves back into the economy. If reverse repo works as planned, those reserves will be lent out manageably, keeping inflation expectations anchored.
Since September 20th, 2013, the Federal Reserve Bank of New York has conducted tests of its overnight reverse repo operations in small amounts. As minutes of Federal Open Market Committee meetings show, the Fed wants to assess reverse repo’s effectiveness as part of “prudent planning” before it normalizes policy. In March, the take up on these repo tests “reached a record level of about $240 billion.” The rating agency Fitch reports similar demand, noting that market participants are now looking to the Fed to borrow Treasury and agency securities. This bodes well for the future functioning of the tool.
What to Look for Moving Forward
While it is expected that the Fed will not move to raise rates until the middle of 2015, there will be key clues to their plans in the coming months. In April’s meeting, the FOMC agreed to continue discussing how to deploy these new tools. The Sunshine meeting notice for the June 17th meeting of the FOMC showed that they again considered “medium term monetary policy issues.” The minutes of that meeting will be released July 9th.
While they probably will not contain any concrete decisions, it will be revealing to compare how their thinking has evolved since April. It did not appear that any one tool has emerged by then as the principal means to normalize policy. So any indication of the balance between normal measures, reverse repos, and interest on excess reserves will be an important signal.
