The Federal Reserve, which cut short-term interest rates nearly to zero at the end of 2008, is considering raising them sometime this year. But it can’t move interest rates the way it did before the financial crisis. Here’s a primer on how the Fed plans to exit from the long period of extraordinarily easy credit.
How would the Fed normally raise interest rates?
By influencing the federal funds rate, the interest rate at which banks lend reserves to each other overnight. Banks are required to hold a certain amount of cash in reserves at the Fed against deposits; any funds held above these requirements are called “excess reserves.” When a bank needs additional reserves, for example, to meet their reserve requirements, it can borrow funds from other banks with excess reserves. This market for bank reserves is referred to as the federal funds market. In normal times, the Fed raises rates by selling Treasury bills or bonds to securities dealers, which pay for them through deposits they hold at banks. Those banks then draw down their excess reserves when moving money from the dealers’ deposit accounts to the Fed. The reduced supply of excess reserves in the banking system means banks have fewer reserves to lend, creating an imbalance between the demand for and the supply of bank reserves. This imbalance causes an increase in the fed funds rate, which then influences other market rates, including the ones that businesses and consumers confront. This process of targeting interest rates by purchasing and selling government securities to change the amount of reserves in the system is normally referred to as “open market operations.” The Fed still plans to target the fed funds rate, but it won’t be doing it exactly as it did before.
For more information, see:
- “Credit and Liquidity Programs and the Balance Sheet” by the Federal Reserve Board of Governors for a more detailed explanation of the Fed’s balance sheet.
- “Open Market Operations,” by the Federal Reserve Bank of New York for a more detailed description of open market operations.
Why shouldn’t the Fed use open market operations to raise rates today?
Before the financial crisis, banks held about $25 billion in reserves on average, meaning that just a few billion dollars of open market operations could move the fed funds rate up and down. Today, as a result of the Fed’s bond buying, known as quantitative easing, banks hold almost $2.5 trillion in excess reserves. To raise rates, the Fed would need to sell trillions of dollars in securities in order to absorb the trillions of dollars in reserves, a process which would likely be disruptive to financial markets and have unpredictable effects. But, in anticipation of the time when policymakers decide to raise rates, the Fed has identified and experimented with alternative mechanisms for pushing up short-term rates. Two tools in particular—interest on excess reserves (IOER) and reverse repos—allow the Fed to raise its policy rate, irrespective of the size of its balance sheet.
See “Conducting Monetary Policy with a Large Balance Sheet,” by Fed Vice Chairman Stanley Fisher’s, February 27, 2015.
What is interest on excess reserves (IOER) and how does it work?
Before the crisis, the Fed paid no interest on excess reserves, but in 2008, it started paying interest at a rate of 0.25%. The Fed is widely expected to raise the Fed Funds rate by increasing the amount it pays in interest on excess reserves. Banks earning IOER have little incentive to lend funds at any rate below IOER, since they could park cash at the Fed and earn the higher IOER rate. As a result, an increase in the IOER rate should bring an increase in the fed funds rate.
See “Interest on Excess Reserves and Cash ‘Parked’ at the Fed,” by Gaetano Antinolfi and Todd Keister, August 27, 2012.
Are there any drawbacks to the Fed’s use of IOER as a way to push up interest rates?
The Fed is confident that the tool can work as it intends in the markets, but it may create political problems for the Fed. Some politicians and citizens are likely to view IOER as a gift to banks at the expense of the taxpayer. But that view stems mostly from a misunderstanding of how IOER works. According to Fed Chair Janet Yellen: “We will be paying banks rates that are comparable to those that they can earn in the marketplace, so those payments don’t involve subsidies to banks.” The Fed’s monetary policy operations determine the total amount of bank reserves and cash in the system. To finance themselves, banks have to raise money in the market. As banks earn more in IOER when the Fed pushes up rates, the banks’ funding costs also increase, leaving their profits mostly unchanged.
For more detail, see:
- “The Economic Outlook and the Role of Monetary Policy” by President Bill Dudley of the New York Fed, March 25, 2013.
Are there technical shortcomings of using IOER as a monetary policy tool?
Yes. A significant portion of the U.S. financial system is comprised of money market funds, government-sponsored enterprises, hedge funds and other financial institutions which are not banks. Though they hold substantial cash, they cannot hold deposits at the Fed and earn the IOER. So if the Fed raised IOER, these cash-rich institutions might be willing to lend funds at rates below IOER, which could push the fed funds rate below the Fed’s target—and indeed that’s what’s been happening over the past six years.
See “Monetary Policy Lessons and the Way Ahead,” by Fed Vice Chairman Stanley Fisher, March 23, 2015, for more detail.
How would reverse repos address this problem?
If the fed funds rate remains below the Fed’s target the Fed can rely on another tool: reverse repurchase agreements. A reverse repurchase agreement, or reverse repo, is an overnight loan collateralized by Treasury securities. The Fed borrows funds overnight from a broad set of financial institutions, including those that cannot receive IOER, and repays the lender the next day with interest (at the reverse repo rate). From the perspective of the money market fund or other institution transacting with the Fed, the reverse repo is functionally similar to holding an interest-earning reserve deposit at the Fed (reverse repos are actually even safer since they are collateralized by Treasuries). Like banks receiving IOER, reverse repo lenders have no incentive to lend at rates below what the Fed offers. Because the reverse repo rate functions as a lower bound for the fed funds rate, raising the reverse repo rate would increase short-term market rates, generally. However, there are risks to the reverse repo program. For example, in times of stress, money market funds may stop lending to the private sector, choosing instead to lend to the Fed (a safe counterparty)through reverse repos, disrupting money markets. As a result the Fed has made clear that it will only rely on the reverse repo facility as a backstop and has limited the amount of RRPs it will do. .
For more information, see:
- “Monetary Policy Lessons and the Way Ahead,” by Fed Vice Chairman Stanley Fisher, March 23, 2015.
- “Reverse Repo Risks,” by Steve Cecchetti and Kermit L. Schoenholtz, June 26, 2014.
What about the Fed’s huge portfolio of bonds and mortgages?
The Fed’s balance sheet has been stable at about $4.5 trillion since it ended QE in October 2014. The Fed has said it is in no rush to shrink the balance sheet. For now, it is reinvesting the proceeds when bonds mature or mortgages in its portfolio are paid off. Sometime in the future, the Fed plans to stop reinvesting the proceeds of maturing bonds and mortgages to gradually reduce the size of the balance sheet. But it says it doesn’t anticipate selling its mortgage-backed securities. Former Fed Chairman Ben Bernanke has said “There is absolutely no need or requirement for the balance sheet to go back to normal as monetary policy normalizes. The balance sheet could be kept where it is for a very long time if necessary.” Several other major central banks have long had larger balance sheets, relative to their size of their economies, than the Fed, including Japan and Switzerland. But the Fed has made clear that, in the “longer run,” it will “hold no more securities than necessary to implement monetary policy efficiently.”
For more information, see:
- “Interest Rate Control during Normalization,” by Simon Potter, October 7, 2014.
- “The Rise and (Eventual) Fall of the Fed’s Balance Sheet,” by Lowell R. Ricketts and Christopher J. Waller, January 2014.