The Fed's Fight for Control of Its Key Interest Rate

The Fed's Fight for Control of Its Key Interest Rate

Photographer: Andrew Harrer/Bloomberg
Photographer: Andrew Harrer/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 what the Federal Reserve is attempting to do as the fed funds rate inches closer to the top of the central bank’s target range. Yet even after an unprecedented change to one of its key policy-setting tools in June, the gap between the fed funds rate and the upper bound of the range continues to narrow, and is once again at its smallest in almost eight years. That potentially sets the stage for further adjustments in the months ahead as policy makers look to tighten control over what is arguably the most important interest rate in the world.

1. What’s going on?

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. It set a target range for the fed funds rate of 0.25 percent to 0.5 percent. Since then it’s increased the range another seven times, to 2 percent to 2.25 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 the year, fed funds has been creeping higher, now sitting just five basis points below the top of the range, at 2.20 percent.

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, 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 those 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 interest on excess reserves (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 withdraw reserves and lend them to other financial institutions at that higher rate. But that increase in the supply of reserves available for 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.

6. Why is the fed funds rate 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, is that elevated Treasury-bill supply -- and a corresponding increase in yields -- is contributing to the benchmark’s rise. That has pushed other key overnight rates higher, 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 funding has lessened, putting upward pressure on the effective fed funds rate. Some strategists also believe that the central bank’s balance-sheet unwind is also starting to have an impact.

7. Didn’t the Fed already make an adjustment?

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. 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, to 1.95 percent. But given that the fed funds rate keeps edging higher, Wall Street is wagering they’ll be forced to act again. In fact, trading in fed funds futures suggests markets now see another adjustment as all but assured by year-end.

8. Will it work this time?

The Fed would seem to think so. 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, aren’t so sure. He sees the adjustments as 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. Should the Fed make another adjustment this year, it would put the gap between IOER and the rate on the Fed’s overnight reverse repo facility at 15 basis points. Further tightening in the IOER spread relative to the RRP rate could create “extreme stress” for banks in terms of liquidity, according to Michael Cloherty, the head of U.S. interest-rate strategy at RBC Capital Markets. Officials may only be able to tweak the IOER rate two more times -- including a December adjustment -- according to strategists at Bank of America Corp.

The Reference Shelf

  • The transcript of Fed Chairman Jerome Powell’s September meeting press conference.
  • A roundup of analyst opinions ahead of the November FOMC meeting.
  • Why the Treasury is being blamed for the Fed losing control of overnight rates.
  • A Federal Reserve Bank of St. Louis paper, "Interest Rate Control Is More Complicated Than You Thought."