The Federal Reserve has formidable powers to help steer the United States’ $20 trillion economy. So when it makes even the smallest of tweaks to one of its tools, take note.
On Wednesday, the central bank adjusted how it sets the interest rate on excess reserves. For those unwilling to go down the rabbit hole: Just know that the apparent aim of the change is to make sure that monetary systems function smoothly as the United States economy heats up.
But for those who want to know more, let’s look at how the Fed is steering the economy.Fed rates: A primer
The main tool at the central bank’s disposal is the federal funds rate. This is the interest rate that it uses to influence the cost of borrowing across the economy. When the Fed raises this rate, it sets off a cascade of increases in the interest rates that banks and other lenders charge.
In fact, the Fed targets a range for the federal funds rate. It on Wednesday raised that range to 1.75 percent to 2 percent, from 1.5 percent to 1.75 percent.
Now for a more subtle point. The interest rate on excess reservesplays a supporting role to the fed funds rate in monetary policy. Previously, the Fed set the interest rate on excess reserves at the same level as the top of the- fed funds rate. But on Wednesday the Fed said the interest rate on excess reserves would now be set 0.05 percentage point below the top of the range.
As a result, the interest rate on excess reserves is now 1.95 percent.Why the interest rate on excess reserves exists
After the financial crisis of 2008, the Fed wanted interest rates to stay low and for banks to keep lending. To do that, the Fed effectively printed money and used it to buy trillions of dollars worth of bonds. Banks turned around and deposited much of that money back at the Fed. Banks’ deposits at the Fed are called reserves, and before the crisis banks would try and keep a bare minimum at the central bank. But because the Fed’s bond-buying program pumped so much money into the financial system, banks had huge amounts of “excess” reserves. Today, those reserves total $1.89 trillion.
So, why would the Fed pay interest on these excess reserves? The rate was introduced to give the Fed control over the reserves. Banks can turn reserves into real money by making loans. If banks make too many loans, the economy could overheat. To guard against that, the Fed introduced the excess reserve rate. If the economy is growing too quickly, the Fed can raise the interest rate on excess reserves to persuade banks to keep money at the Fed, rather than deploying it in the economy.Why was the rate changed?
Right now, the Fed doesn’t need to use the rate on excess reserves as an emergency brake. But the rate does play a role in the Fed’s monetary policy.
Start with the overnight market, in which banks borrow money from other financial institutions, known as the fed funds market. Here, banks borrow money, paying an interest rate that is within the Fed’s targeted range for the federal funds rate. The banks may then deposit that money at the Fed, where it will earn the interest rate on excess reserves that is a tiny bit higher than the fed funds rate at which they borrowed.
But recent developments in the fed funds market prompted the Fed to make its change.
The government has recently been issuing a lot more debt to finance its deficit, much of it in the form of Treasury bills that are sold to investors. But to find sufficient buyers, the Treasury has had to pay higher rates on Treasury bills. This helped attract money out of the federal funds market into Treasury bills, and in turn that caused the fed funds rate to move higher and closer to the top of its range.
This caught the Fed’s eye. The central bank, according to analysts, wants to avoid a situation in which the fed funds rate moves above the Fed’s target range. “The Fed doesn’t want anyone in the market to think it’s not in control of overnight rates,” Lou Crandall, chief economist at Wrightson ICAP, said. “It might worry some people if it went above the upper band.”How does the change help?
Imagine that the Fed still set interest rate on excess reserves at the top of the range of the fed funds rate. Banks could go and borrow overnight funds at, say, 1.95 percent and deposit them at the Fed and earn 2 percent, netting the 0.05 percentage point profit. But such trades might continue to lift the federal funds rate, set in the market, too close to the upper band for the Fed’s comfort. That’s because the excess funds rate would be set at the upper band of the federal funds rate.
But now, with the rate on excess reserves set at 0.05 percentage point below the upper band, the banks doing that kind of arbitrage trade would have to borrow in the fed funds market at 1.9 percent to earn the same profit margin. As a result, the market may set the federal funds rate further below the upper band — which is what the Fed wants.
Big challenges still lie ahead. As the Fed reduces the stockpile of bonds it acquired through its bond buying program, it takes money out of the economy, and banks’ excess reserves fall. This could make it harder to keep interest rates at levels appropriate for the wider economy. While the tweak to the rate on excess reserves shows that the Fed is prepared to be flexible, it will need to remain so. “This may be step one,” Jim Vogel, a fixed income strategist at FTN Financial, said.