13 Juni 2018, 12:59 GMT
The FOMC currently sets a target band for the overnight rate for uncollateralised lending between banks, the fed funds rate, and also sets the interest rate that they pay on excess reserves, the IOER. The IOER is currently set to be equal to the upper end of the target band. Since the beginning of the year, the federal (fed) funds rate has steadily risen towards the top of its target range. In response, the FOMC minutes reveal they are likely to adjust down the interest rate they pay on excess reserves (the IOER), relative to the top of the target range, by five basis points to be more confident of keeping the fed funds rate within the target range.
The main driver of the move higher in the fed funds rate has been increased T Bill issuance by the treasury, which has driven up bill yields and pushed up short term rates as well. However, the bigger worry for the Fed is that some of the upward pressure on money market rates has been due to reserve scarcity. That reserve scarcity could be happening so early in the process of unwinding quantitative easing would be evidence that the natural level of reserves in the system is far higher than previously thought. It implies that they would have to taper or suspend the balance sheet reduction far earlier than projected.
The Fed’s own projections include a range from $400 billion of reserves at their minimum or ‘normalised’ balance sheet, which would happen in 2023, to $1 trillion of reserves, which would happen in 2020. (https://www.newyorkfed.org/medialibrary/media/markets/omo/SOMAPortfolioandIncomeProjections_July2017Update.pdf) After the balance sheet hits its minimum size, the Fed will become net buyers of Treasuries again. If the natural level of reserves is at the high end of the range, as we suggest above, it means they will become buyers sooner rather than later.
Ultimately, the recent moves have brought forward the decision of how the Fed will run monetary policy in the long run. The trade-off between the options is the degree to which the Fed can reduce the balance sheet. If they want to operate with abundant excess reserves, they will control the fed funds rate by setting IOER within the target range. This will limit the extent to which they can reduce the balance sheet, and mean that they become net buyers of Treasuries sooner. If they want to operate with a scarcity of reserves, IOER will act as a floor to fed funds and the discount window as a ceiling for the target range. This will allow the Fed to run down their balance sheet for longer, but also implies scarcer reserves, lower money supply and tighter financial conditions globally.
The decision on how to run monetary policy will, in large part, come down to how determined the Fed is to significantly reduce its balance sheet.
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