John Hilsenrath has an important piece in today’s Wall Street Journal on the future of interest rates. I wanted to outline some thoughts here because I still think there’s a good deal of confusion about what has gone on and what could go on in the future with regard to the maintenance of interest rates and the Fed’s balance sheet. Here’s the basic gist of Hilsenrath’s piece:
- The Fed has traditionally controlled interest rates via the Fed Funds target rate which involves targeting an interest rate by setting the level of reserves in the interbank market. By flooding the system with reserves the Fed can loosen policy and entice banks to lend reserves to one another thereby putting downward pressure on rates. Likewise, when the Fed wants to tighten policy they can remove reserves and eliminate the desire to lend reserves.
- The crisis put the Fed in an awkward position. They set rates at 0%, flooded the system with reserves and implemented their unusual asset purchase program which resulted in an unusually large Fed Reserve balance sheet.
- As I’ve often mentioned, this increase in reserves caused serious concerns over future potential inflation and created concerns over the ability to tighten policy. If inflation picked up quickly the Fed might need to tighten, but given the extraordinary size of their balance sheet they might not have the tools to tighten policy without being forced to quickly reduce the size of their balance sheet thereby putting pressure on asset prices and potentially creating instability in the economy. This meant that the Fed needed new tools to manage future potential inflation risks.
- The payment of interest on reserves reduced this risk by giving the Fed the ability to pay banks interest on their reserve holdings. This reduced the desire to lend reserves in the interbank market and helped establish a floor under interest rates. This tool would allow the Fed to maintain a massive balance sheet without having to worry about having to reduce the balance sheet to raise rates. Instead, the Fed can just raise the IOR which acts as a de facto Fed Funds Rate.
- The only problem with this is that there are some entities (like the GSEs) which trade in the interbank market but are not eligible to be paid IOR. So these firms are putting doward pressure on the overnight interest rate making the Fed’s payment of IOR less effective and potentially less stable than it otherwise would be.
- The Fed has implemented the full-allot
ment overnight reverse repo facility to allow non-banks to enter into overnight repos with the Fed at a fixed rate. This would circumvent the law banning the Fed from paying interest on reserves by allowing the Fed to pay interest on overnight loans via the repo facility. In essence, the Fed would become a major player in overnight loans outside the interbank market. This would help them set the target rate more effectively and would likely tighten the spread. When it comes time to raise interest rates this will give the Fed one more tool to implement a smooth increase in rates.
That’s the basic rundown of what has gone on and what will go on when it comes time to raise rates. So don’t be too concerned about a potential exit strategy. I don’t think it will be as big a concern as some might think and the size of the Fed’s balance sheet really shouldn’t pose a problem. But I think there’s a very important line in Hilsenrath’s piece. He closes by saying:
“Fed officials have time. Most of them don’t expect to raise rates until next year.”
Exactly right. Given the weak economic growth, low demand for credit and low inflation I would be shocked if we’re talking about rate increases any time soon.