CNBC Explains

Here's how the Fed actually raises interest rates

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How the Fed rate hike affects the stock market
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Inside the mind of the Fed
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For the Fed, voting to hike interest rates is the easy part. The tough work begins as U.S. central bank officials implement the right maneuvers to ensure rates go where they want.

Essentially, the heavy lifting gets assigned to bond traders at the New York Fed who use a few tools to ensure that supply and demand work out so that the primary policy target, or funds rate, is within the range the Federal Open Market Committee expects.

If things go as Wall Street expects, the Fed will be lifting the current funds rate target from 0 to 0.25 percent to 0.25 to 0.50 percent — a number that the investors will see as a quarter-point hike, though the mechanics may not quite work out that way.

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Specifically, the Fed will be using two tools: interest on excess reserves, or IOER, and reverse repurchase operations, or RRP. The former involves payments on the $2.3 trillion or so of excess reserves banks currently hold at the Fed, while the latter are short-term — almost always overnight — purchases of a security with the agreement to sell later at a higher price.

How it all works is that the New York Fed's trading desk gets its cue for what the overnight funds rate target is, then uses the IOER and RRP "such that the aggregate supply of banking reserves roughly matched prevailing reserve demand," Elad Pashtan, U.S. economist at Goldman Sachs, said in a recent report for clients explaining the process.

Janet Yellen, chair of the U.S. Federal Reserve, from right. Scott Alvarez, general council with the U.S. Federal Reserve, Stanley Fisc
Andrew Harrer | Bloomberg | Getty Images

The effort will be an attempt to drain reserves at a level that keeps the funds rate in the range the FOMC specifies, likely close to 0.50 percent from the current 0.14 percent. Bank of America Merrill Lynch strategists believe the rate actually will settle around the 0.32 to 0.34 percent range. The changes will be implemented the day after the committee approves the rate hike.

(Deutsche Bank has this very cool infographic that helps show the various machinations that go into setting the funds rate.)

The Fed will use arbitrage as its lure for the sales, giving participants the incentive to borrow reserves overnight to earn the higher returns through the IOER and RRP operations.

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Making sure the process goes off correctly is where the alchemy comes in. Once the Fed works its magic, the rest of the rate markets will follow, with banks resetting the prime rate they use to charge borrowers and credit card holders. The effects will ripple through the economy.

The Fed has never had to conduct rate operations with $2.42 trillion in reserves and a $4.5 trillion balance sheet consisting of the various debt products — primarily Treasurys and mortgage-backed securities — it has purchased since conducting three rounds of quantitative easing in a six-year period starting in 2008.

"In a world of zero rates, these excess reserves pose few challenges for implementing monetary policy," Pashtan said. "However, in a non-zero rate regime, excess reserves create a challenging operating framework for the Federal Reserve as it seeks to raise overnight funding rates."

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The Fed will set caps on how much it trades, with the current $300 billion raised to about $750 billion or $800 billion, according to various estimates on Wall Street.

"The cap is likely to remain elevated initially, as the committee's desire to set a firm floor on money market rates outweighs any concerns with elevated caps," Pashtan said. "Over time, the cap is likely to decline as policymakers grow more comfortable with the supply/demand dynamics of the facility and reserve balances shrink as portfolio runoff commences."

Bank of America Merrill Lynch provides a good explainer:

We expect that the Fed will increase the ON RRP cap to somewhere between $500 billion and $800 billion at liftoff. This should provide adequate headroom to meet demand, which we think will initially total $200 billion to $300 billion. A cap at the high end of this range (or even above it) would demonstrate a strong commitment from the Fed to raise short-term interest rates. We think the Fed will prefer to set the cap at a higher level and gradually reduce it over time after it sees where the typical demand settles. Along with an increase in the aggregate cap, we would not be surprised to see the Fed increase the per-counterparty cap from $30 billion to potentially as high as $50 billion.

The Fed currently pays 0.25 percent interest on excess reserves and has a 0.05 percent rate on the RRP operation.

Should the IOER-RRP strategy fail to work — and there are fears it won't due to the size of the operations — the Fed either can expand the programs or conduct short-term asset sales, a scenario generally considered unlikely but certainly on the table.

While the central bank ultimately will have to shrink its mammoth balance sheet, most expect that process won't begin for a few years.

"Fed officials have communicated their concerns that asset sales pose the risk of sending unintended hawkish policy signals, along with the potential to create unexpected financial market reactions," Pashtan said. "Accordingly, we do not expect any balance sheet normalization until mid-2017."