The latest FOMC minutes provided some clarification on the approach the Fed is expected to take as it begins normalizing short term rates in the US. Here is a quick overview of the Fed’s strategy and potential implications.
The Fed has chosen the interest rate on excess reserves (IOER) as the primary tool to control interest rates during the normalization process. While working with IOER is certainly more effective than the Fed Funds rate, there are a some drawbacks. As banks pay nearly nothing on deposits and earn an increasingly higher rate on reserves, the Fed will be criticised for providing banks with more riskless profits (on some $2.5 trillion of excess reserves).
To mitigate this thorny issue, the Fed will also rely on the reverse repo program (RRP). The FOMC now views RRP as playing a “supporting role” of providing a floor on repo rates. Keeping repo rates from getting too low will allow money market funds to offer higher rates to their clients. At least in theory that is supposed to provide competition for deposits, forcing banks to raise deposit rates and limiting the deposit-to-reserves arbitrage. The FOMC wants to see the spread between IOER and RRP at around 20bp or higher.
Fed Minutes: – The appropriate size of the spread between the IOER and ON [overnight] RRP rates was discussed, with many participants judging that a relatively wide spread–perhaps near or above the current level of 20 basis points–would support trading in the federal funds market and provide adequate control over market interest rates. Several participants noted that the spread might be adjusted during the normalization process.
For example the Fed could set IOER to 50bp and RRP to 30bp. That would put money market rates at say 45-60bp and bank bank deposit rates at something like 25-35bp (currently the national average is 11bp on bank savings accounts), capping the IOER-to-deposit-rate spread.
The FOMC seems to be uneasy about a more aggressive use of the RRP, fearing that in times of crisis the participants will pile all their liquidity into the Fed facility, draining the reserves, and taking liquidity out of the private sector.
