Beyond the ongoing debate inside the Fed over when to execute an exit strategy, an equally important debate is underway about how to execute it.
The likelihood is that a new monetary policy regime will take hold, and it will be of an order of magnitude similar to the change that took place when the Fed moved from targeting the level
of borrowed reserves to targeting the Fed Funds rate directly in the mid-1980s. That will mean investors will have to learn new ways to read the central bank’s tea leaves.
In the new regime, the Fed Funds rate is unlikely to be the most important tool for setting policy. The new kid on the block, the interest rate on excess reserves, or IOER, will hold that place.
Fed officials are currently puzzling over how to calibrate multiple moving parts of its exit strategy --- the interest rate it pays on excess reserves, the level of excess reserves and the fed funds rate. What’s become clear to Fed officials is that, in a world of $1 trillion of excess reserves, the fed funds rate no longer matters the way it once did.
In the old world, the Fed Funds market was the marginal source of funds for the banking system. By conducting open market operations where it drained or added reserves to the system, it could raise or lower the funds rate. The funds rate, in turn, was a critical determinant of other market interest rates. (In fact, markets were so certain in the Fed’s ability to adjust the rate where it wanted them to be, that the Fed had to do little in the way of actual operations. When it announced a change, the market automatically adjusted to it through what fed watchers call “the announcement effect.”)
But the Fed Funds market is now a shadow of its former self. Banks have ample reserves (actually more than ample) so they don’t need to go into the Fed Funds market. The IOER has been pegged at 25 basis points but the Fed Funds rate fluctuates around 12 basis points. The reason: government sponsored entities such as Fannie Mae and Freddie Mac can’t earn the IRER. So they dump their excess cash in the Fed Funds market and can only get half of what the banks get at the Fed.
The result: the Fed is not sure what will happen to the Fed Funds rate when it starts to take the punch bowl away. Speaking last month, Brian Sach, the new head of the NY Fed’s open market desk, underscored the concern over the spread between Fed Funds and the IOER: “Policymakers face some uncertainty about how stable that spread will remain as short-term interest rates increase….In my view, the most likely outcome is that the spread will not widen substantially as short-term interest rates increase. However, if the spread does become large and variable, then policymakers will need other tools for strengthening their control of short-term interest rates.
Reverse repurchase agreements and certificates of deposit will also be used to tie up banks funds. And the higher the interest rate on reserves, the more a bank is incentivized to leave those excess reserves on deposit at the central bank and not lend it out into the economy.
Ultimately, the fed will be watching how all of this plays out in the Libor market and other real market interest rates that influence the economy.
Wrightson ICAP’s Fed observer Lou Crandall says the Fed has two choices for the Fed Funds rate: it can set it in a range or it can just stop setting it all together. Investors need to watch the IOER as the most important tool of monetary policy, he says.
Fed officials haven’t figured all of this out yet but feel they still have time to puzzle it through in part because they don’t intend to reverse policy anytime soon. The obvious concern is likely that talking about this now publicly will raise market expectations of an imminent change.