Along with an expected rate hike in December, some central bank watchers expect the Federal Reserve to approve another tweak to ensure that its current policy path, which has come under increasing pressure lately, proceeds smoothly.
If the Fed is unable to manage the range where it keeps its benchmark interest rate, that could lead it to halt the unwinding of its balance sheet comprised of bonds it purchased to lower mortgage rates and stimulate the economy. The economic and market ramifications could be substantial, though there’s no indication now the Fed is considering halting the balance sheet reduction.
The market has long been expecting the Fed to go through with a 25 basis point (0.25 percentage point) increase in its benchmark funds rate at the year’s final Federal Open Market Committee Meeting.
Under normal circumstances, such a move would be accompanied by a commensurate quarter-point hike in the interest the Fed pays on excess reserves from banks, or the IOER. The current level is 2.2 percent, compared to the 2 percent to 2.25 percent range for the funds rate.
However, the funds rate has risen near the top boundary of its range, to 2.2 percent to equal the IOER, and that presents a problem.
The Fed uses the IOER to guide the funds rate, generally as a floor for where the funds rate should be. The central bank manages its funds rate through the interest rate on reserves and its overnight repo facility, which also helps the Fed to set a floor on rates.
This year, as government debt issuance has surged and rates have increased on the repo purchases in which the Fed has purchased, the funds rate has drifted to the upper end of its target range.
Back in June, the Fed addressed the issue by raising the IOER just 20 basis points to try to push the funds rate more toward the center of the range. That worked for a few months, but the two rates have drifted closer together and on Oct. 23 met at 2.2 percent.
The Fed has “lost control over rates” at the upper bounds of its target range, said Michael Pearce, senior U.S. economist at Capital Economics.
More scrutiny over rates
Though “none of this is too troubling for the Fed” so long as it is again able to manage the funds rate back down to the middle of the range, continued pressure could result in a policy change.
Fed officials did not immediately respond to a request for comment.
“With reserves abundant, it is unlikely that the effective funds rate will rise much above the IOER,” Pearce said in a note. “If it did, however, the Fed would presumably conclude that there was less excess liquidity than previously believed and, as a result, bring its quantitative tightening to a premature end.”
Importantly, Fed officials noted in minutes from the last FOMC meeting that the rise in the funds rate did not seem to emanate from a lack of reserves, which would be more troubling. The Fed is allowing up to $50 billion worth of Treasurys and mortgage-backed securities run off its balance sheet each month in an effort to reduce the bond portfolio from its $4.5 trillion peak, with the current level at $4.2 trillion. Indications that reserves are tightening and pressuring rates higher might push the central bank to ease off the balance sheet reduction.
The issue arises at a time, however, when the Fed is facing increasing scrutiny over whether it should continue hiking rates and drawing down the balance sheet, a process the market has come to call “QT” for quantitative tightening. President Donald Trump has sharply criticized the Fed for raising rates, and bank analyst Dick Bove said in an essay for CNBC.com that the central bank is “imposing a new rigid financial system on the economy.”
However, the September FOMC meeting summary noted that the balance sheet program has produced a “muted” market reaction so far.
Whether that continues, though, could depend on the relationship between the IOER and the funds rate.
Citigroup economist Andrew Hollenhorst said he even has fielded questions about whether the Fed might cut the IOER rate to 2.15 percent at the Nov. 6-7 FOMC meeting to further put the clamps on the funds rate.
“Communicating a 5bp cut in a key policy rate in the midst of policy normalization presents obvious drawbacks,” Hollenhorst said in a note. “Consequently we think a 5bp cut in November is unlikely unless [the Fed funds rate] is printing above 2.25% (unlikely, in our view).”
In the wake of significant market volatility in October, traders have reduced their probability of a December funds rate hike to 74 percent, from 87 percent a week ago, according to CME data. The probability of a March 2019 increase is down to 48 percent from about 62 percent a week ago.