The Federal Reserve’s tool kit for controlling interest rates is facing a challenge that could prompt changes in the mechanics of how the central bank influences the economy.
The Fed’s benchmark federal-funds rate has in recent weeks traded near the top end of its range between 2.25% and 2.5%, exceeding another rate that is supposed to cap it.
Something similar happened twice last year. And when it did, the Fed responded with technical tweaks to its rate regime. Some analysts say that could happen again, either at the conclusion of the Federal Open Market Committee meeting Wednesday, or at the June gathering.
But others reckon the Fed might need to make bigger changes to keep control over short-term rates, which it adjusts to achieve its goals of a strong labor market and low, steady inflation.
While analysts are divided about whether this condition will persist, “there are negative implications,” said Thomas Simons, a money-market economist at Jefferies Financial Group. “It reduces the confidence of the market in the Fed’s tools.”
The rise in the effective fed-funds rate—where it is driven by the market daily—stems from its reduction of reinvestments in maturing Treasury securities, bond market analysts said. The Fed’s decision to buy fewer securities has left it to bond dealers and other private investors to use more of their cash to pick up that slack by purchasing more U.S. government debt.
That has exacerbated a common seasonal event in April, in which cash becomes scarce in funding markets as companies dip into money-market funds to make tax payments. JPMorgan estimates that more than one-third of the $2.4 trillion in these portfolios at the end of March were invested in overnight-repurchase agreements, or repos.
This is important because broker-dealers borrow cash in the repo market to finance operations. The shortage of cash has allowed lenders to raise overnight rates to a recent 2.534%, which is above those for Treasury securities maturing in 10 years or less. Higher repo rates make it more expensive for dealers and other investors to hold securities with borrowed funds, and drives up the clearing level for reserves, analysts said.
Right now, the Fed controls rates through an approach it formally adopted in January. It seeks to keep the fed-funds rate in a range. The bottom end is set by the so-called reverse-repo rate, which the Fed pays to money managers and other eligible firms to park money at the Fed
The top had been determined by what is called the interest on excess reserves rate, or IOER, which the Fed pays to deposit-taking banks on the money they keep at the central bank, called reserves.
The episodes last year drove the Fed to lower the IOER rate relative to the top end of the range: It is now 2.40%.
The fed-funds rate has crept up in recent weeks to above the IOER rate. In recent days it has been trading at around 2.44%.
Morgan Stanley told clients in a note that it is expecting the Fed to lower the IOER rate to 2.35% on Wednesday. Bank of America and TD Securities don’t offer a time frame, but say if the fed-funds rate moves even closer to 2.50%, the Fed will lower the IOER rate.
If what is going on with short-term rates might be related to tax season, however, the Fed would want to wait to see if the issue is transitory.
David Beckworth, a senior research fellow at the Mercatus Center at George Mason University, thinks lowering IOER again won’t work. Regulatory issues and big government deficits are creating pressures on short-term rates, he said. Dropping the IOER again will likely make the issue worse because it creates incentives for short-term lending market participants to pursue higher market rates, moving money off the Fed balance sheet in a way that will erode control over rates, he said.
Others say there may be a case for a broader overhaul of rate-control mechanics. That is largely because the fed-funds rate, while historically important, has much less value in a world where banks hold large quantities of reserves.
Former New York Fed President Williams Dudley said in an interview Tuesday he supports dropping the fed-funds rate as the primary focus of monetary policy and using IOER instead as the chief rate tool for influencing the economy.
Write to Michael S. Derby at michael.derby@wsj.com and Daniel Kruger at Daniel.Kruger@wsj.com
https://www.wsj.com/articles/upward-move-on-key-market-rate-could-bring-fed-response-11556703002
2019-05-01 09:30:00Z
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