As the Federal Reserve approaches lift-off from the zero lower bound, it is important to note that this rate hike cycle will be unique in ways most investors may not appreciate.
In the past, the Fed would adjust its main policy rate by controlling the supply of reserves. But the Fed’s quantitative easing programs over the past few years have created an unprecedented volume of excess reserves – cash sloshing around the banking system –making it more difficult for the Fed to control the supply of reserves.
So the Fed will rely on two new devices which it hopes will work better and contain its policy rate in a defined range. The upper bound of the Fed’s new policy range will be established using a new facility called the IOER (Interest On Excess Reserves). The lower bound of the Fed’s new policy range will be established using the new Reverse Repurchase facility (RRP).
When the Fed finally does announce its first rate hike, it will not target a specific policy rate; rather, it will define a range – likely to be 25 bps‒50 bps for the first move – with the actual fed funds rate bouncing around within this range.
Here is the concern: Normally, yields on other short-dated instruments closely follow the fed funds rate, and in this way, the Fed is able to guide all interest rates in the economy; but this link may now be broken. Regulatory changes, including money market reforms and new bank regulations, have significantly increased demand for short-dated, “safe” assets. The Fed’s new devices, in their current form, may not successfully address this increased demand. In turn, yields on these other short-dated assets may not increase in line with the fed funds rate as they have traditionally.
Will this compromise the Fed’s ability to successfully engineer a normalization of monetary conditions in the broader U.S. economy? We fear it may unless further adjustments are made to the new, more complicated mechanics of conducting monetary policy.