(Bloomberg) -- For all the talk about when Federal Reserve
policy makers are going to raise interest rates, they haven’t
quite figured out how to do it.
The central bank has had trouble controlling near-term
borrowing costs since the 2008 financial crisis and has been
experimenting with ways to do so. While its main new tool has
enabled the Fed to exert more influence over money-market rates
in the past year, strategists from Barclays Plc to Goldman Sachs
Group Inc. say the program is too small to prevent rates from
falling when officials want them to climb.
At issue is the Fed’s balance sheet, which has ballooned
through its bond buying, leaving over $2 trillion in excess
reserves in the banking system that may prove to be more
difficult to siphon off than in the past. New methods are needed
because the federal funds rate, long the central bank’s primary
policy instrument, has ceased to be an effective means to guide
short-term market rates.
“The likelihood that we are going to get through this
without some form of accident is very small,” said James Camp,
a fund manager at Eagle Asset Management in St. Petersburg,
Florida, that has $31.2 billion in assets. “My concern is that
the rate resetting higher is not very elegant and becomes sort
of clumsy, with a series of fits and starts.”
Fed Questions
Camp, along with money-market economists such as Lou
Crandall of Wrightson ICAP LLC, says the Fed will need to more
than triple the use of its main tool, known as the reverse-repo
program, to at least $1 trillion from the current $300 billion
per day limit.
The facility is intended to withdraw or neutralize cash
outside the banking system. In an overnight reverse repo, the
Fed borrows cash from counterparties using securities as
collateral. The next day, it returns the cash plus interest to
the lender and gets the securities back.
Even though the program should help, Fed officials are wary
of an over-dependence on such facilities, seeing the risk that
it may cause investors to avoid privately issued securities for
the safety of Fed repos in times of turmoil.
“A large and persistent program could have unanticipated
and adverse effects,” Fed Vice Chairman Stanley Fischer said
Monday in New York. “In times of stress, demand for the safety
and liquidity” provided by reverse repos could exacerbate
market disruptions, he said.
Reserves Dilemma
As Fed staffers tinker with the exit apparatus, the policy-setting Federal Open Market Committee last week dropped a
commitment to be “patient” before raising rates, opening the
door to a rise as early as June. The market sees a move later in
2015, given officials also lowered their estimates for the path
of the funds rate over coming years.
In the past, the Fed increased the cost of overnight bank
borrowing by raising the funds rate. The trillions of dollars in
excess reserves that exist, compared with a few billion at the
start of 2007, have obviated the need for banks to borrow daily
and forced U.S. monetary authorities to come up with ways to
influence market rates directly.
It has been evident since 2008, when the Fed gained the
ability to pay interest on excess reserves, that the new rate
wasn’t anchoring borrowing costs as envisioned. Government-sponsored agencies including regional Federal Home Loan Banks,
primary providers of cash in the overnight market, aren’t able
to receive such interest, which has enabled the funds rate to
drift below IOER, now at 0.25 percent.
Tightening Mechanism
To make matters worse, widespread negative yields abroad,
and heightened regulation on banks and money funds, have sapped
the supply of safe short-term assets and buoyed demand. That
further casts doubt on whether a tightening of policy will be
smooth.
Strategists have expressed concern that, when the Fed
starts to tighten policy by raising IOER, other market rates may
not follow, leaving monetary conditions too accommodative. While
banks receiving interest on surplus reserves have dimmed their
desire to dump excess cash into the money markets, the funds
rate has still consistently traded below the IOER. The reverse
repo program thus far has helped provide a floor for the funds
rate.
“Especially in the initial stage of a Fed liftoff, they
are particularly concerned about fed funds sag, which is the
effective slipping below the reverse repo rate,” said Joseph
Abate, a strategist at Barclays. “That would wind up hurting
them in terms of credibility as it would look like the Fed is
struggling to raise interest rates. Overall, you are going to
get a lot more volatility in markets.”
Other Options
Through reverse repos, the Fed aims to set a floor for
short-term rates by temporarily pulling cash from the system
with a wider array of counterparties that includes money-market
mutual funds, its 22 primary dealers and government-sponsored
agencies. Daily cash is removed through the transactions, at a
fixed rate now at 0.05 percent, with Treasuries used as
collateral.
The central bank envisions the fed funds effective rate,
which averaged 0.12 percent this year, floating between the
reverse repo rate and IOER. Last year the rate averaged 0.09
percent.
“It will take somewhat greater use of the Fed’s tools to
get the funds rate into the middle of a 25 to 50 basis-point
range than it does to keep it in the middle of a 0 to 25
range,” said Crandall, chief economist at Wrightson ICAP in
Jersey City.
Along with the overnight reverse repos, the Fed plans to
use similar agreements that extend beyond one day in times of
high demand, such as quarter- and year-end -- as well as term
deposits -- as non-traditional weapons to lift rates.
“At this point, I don’t the Fed could achieve their
desired end goal of managing other short-term rates when they
begin hiking,” said Tyler Tucci, a U.S. government bond
strategist at Royal Bank of Scotland Group Plc’s RBS Securities
unit in Stamford, Connecticut, a primary dealer.sumber; http://www.bloomberg.com/
