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Vince Foster: As Fed Undergoes Regime Change, How Will It Raise Interest Rates?


There is a glut of lendable cash in the money markets relative to the demand from lenders, and this is why interest rates remain near zero. The situation creates a conundrum for policy makers.

There has been much discussion and debate about when the Fed will begin to raise interest rates, but there hasn't been an explanation for how it will do this. The assumption is that sometime after the Fed ends asset purchases, it will hike the Fed funds rate. However. what we don't know is whether it needs to mop up the $2.6 trillion in excess reserves before doing so --  and, for that matter, if the Fed funds rate is even a useful policy rate. At this week's Congressional testimony, Federal Reserve Chairwoman Janet Yellen gave an indication to the method the FOMC will employ to raise short-term interest rates:

Well, it's my expectation that when the time comes to raise the level of short-term interest rates, that we will certainly raise the interest rate that we pay on excess reserves, and [that we] are likely to use a number of complementary tools that we have developed, including -- our toolkit includes overnight reverse repos, term repos, and our term deposit facility. We will use those tools to push up the general level of short-term interest rates. But interest on reserves will be a key tool that we will be using.
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Excess reserves are Fed liabilities that were created to finance asset purchases; thus for every bond purchased, there's a matched reserve credited to the banking system assets. The Fed is currently paying 25 basis-points interest on these excess reserves (IOER), which are cash assets on bank balance sheets.

The other facility that's gaining traction as a policy tool is the Fed's overnight reverse repo (RRP) agreement. A reverse repo is a transaction whereby the Fed borrows cash from the investment community in exchange for collateral. The Fed returns the cash plus interest, and the counterparty returns the collateral. The Fed is currently paying 5 basis points for these overnight transactions on a limited basis but is projected to open it up to a full allotment, meaning it will set the price and take the total supply offered by investors.

Former NY Fed market operations manager Brian Sack recently cowrote a policy brief with the Peterson Institute's Joseph Gagnon to propose a new operating framework for the Federal Reserve that focuses on the reverse repo facility as the primary interest-rate setting tool:

We propose a new operational framework for monetary policy in which the FOMC employs the interest rate on its overnight RRP facility as its main policy instrument and maintains an elevated balance sheet and, hence, abundant reserves. The RRP facility would be implemented as a full allotment facility, providing any amount of overnight RRP transactions to the market at the rate set by the FOMC. The rate at the RRP facility (which we will simply call the RRP rate) would replace the federal funds rate target as the primary policy instrument of the Fed.
The Fed should instead try to achieve an "interior solution" that involves substantial volumes of both reserves and overnight RRPs, with the market determining the allocation between reserves and RRPs according to where the liquidity is valued the most. We believe that this interior solution is best achieved with equality between the IOR and RRP rates, as discussed below. This framework shifts the attention away from using "draining tools" to achieve a target level of reserves and instead focuses directly on controlling the price of overnight liquidity.
Both the interest on reserves and reverse repo facility are completely different policy-making regimes than the Fed funds rate, yet participants seem to assume there's not going to be much difference when the Fed begins to raise rates. The Fed funds rate is a borrowing rate, while IOER and RRP facilities are deposit rates. The Fed funds rate is a function of the demand for money in the banking system. The IOER and RRP are a function of supply.
The supply of money in the banking system is immense. According the Fed's H.8 report of assets and liabilities of the 25 largest commercial banks, of the $14.4 trillion in total assets, $2.7 trillion is in cash assets (reserves) and $2.7 trillion is in securities assets, with $7.59 trillion in loans. As a comparison, before the financial crisis in 2007, cash assets were $300 billion. A measure of lending capacity, the aggregate loan-to-deposit ratio is 75% down from 100% in 2008 and at a three-decade low.

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All else equal, short-term interest rates should rise because lenders demand funds to finance the extension of credit. When the demand for credit is strong, banks will borrow money from depositors or the fed funds market, and rates will rise as the supply of funds is exhausted at various levels. The Fed set the federal funds target rate based on this supply-demand dynamic.
Currently there's a glut of lendable cash in the money markets relative to the demand from lenders, and this is why interest rates remain near zero. This glut of cash presents a conundrum for policy makers who want to get interest rates off the zero bound. If there's a virtually unlimited supply of money available at zero or at 25 basis points on deposit at the Fed, then why would they raise the price? Raising the price you pay for deposits that are already on deposit at lower levels does nothing but incentivize the glut of money to stay put.
This conundrum presented itself this past week when the Fed announced it would be expanding its term deposit facility by raising the interest rate it pays on seven-day deposits to 26 basis points and up to 30 basis points in subsequent steps. Presumably, money on deposit overnight will move to terms to pick up a few extra basis points, but it won't be leaving the Fed's balance sheet. It's just paying more for money that's already there and offered at less. The Fed is essentially bidding through the offered price.
The idea is that with the Fed providing risk-free deposits to banks, other money market investors in the reverse repo facility will be setting the floor on interest rates. It's thought that no lender will accept money market rates below what it can earn at the Fed risk-free. Credit risk borrowers in the money markets will have to pay respective spreads over this risk-free rate. Once the Fed raises these deposit rates, other money market rates will fall in line.
Here's the problem: There's very little demand for financing credit relative to the supply of funds available to finance credit. The banking system doesn't want these excess deposits, and there's little need for Fed funds. The banking system isn't going to pay money for something it doesn't want for free, and it will gladly allow the deposits to leave for higher-yielding Fed deposits. There's a reason interest rates across the money market spectrum remain near zero. Whether it's Fed funds, general collateral repo, Federal Home Loan Banks advances, or LIBOR, the banking system doesn't need or want the money.
Mopping up this excess liquidity is clearly one of the Fed's objectives, and it wants to get off the zero bound, but I don't see how it can meaningfully impact money market rates until the balance sheet is reduced and reserves are paid off. In order for the Fed to create a market for overnight credit, the supply needs to get in line with the demand -- absent outright bond sales, this is going to take years. The banking system is shrinking and needs to shrink more, thus the demand side of the equation is only going to get worse. By leaving the reserves in the system and just raising the prices of deposits (for which there's no demand), the Fed is destroying the price discovery mechanism in the most basic foundation of the banking system and, for that matter, our capitalistic economy.
Twitter: @exantefactor
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