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How to hike U.S. federal funds rates in a glut of liquidity

Asset purchase programs have left the U.S. banking system with USD2.9 trn in (mostly excess) reserves. Raising the target federal funds rate in this predicament relies primarily on increases in the interest rate paid on excess reserves. Moreover, in order to secure a sufficiently pervasive impact, overnight reverse repurchase agreements will likely play an important role. Their exact form will influence whether or not the target floor on money market rates will be “leaky”.

Simon Potter (Executive Vice President and Manager of the System Open Markets Operations at the Federal Reserve Bank of New York), “Implementation of Open Market Operations in a Time of Transition”,  Speech, September 25, 2014

For a more strategic description of the Federal Reserves “exit strategy” view post here.
For a more general discussion of the Federal Reserve’s monetary policy framework view post here

The below are excerpts from the speech. Emphasis and cursive text have been added. 

The very basics of Fed open market operations

“The FOMC is responsible for the use of open market operations (OMOs), which are purchases and sales of securities in the open market for the System Open Market Account (SOMA), the Fed’s securities portfolio.  OMOs are traditionally the primary tool through which monetary policy is implemented.”

“Within the New York Fed, the [Open Market Trading] Desk…is responsible for conducting open market operationsunder the authorization and direction of the FOMC. In practice, the FOMC’s operating objective for OMOs—for example, a target rate for overnight interest rates or a specified amount of assets to purchase—is communicated to the Desk through a policy “directive” that the Committee votes on at the conclusion of each meeting. “

For many decades prior to the crisis, the operating objective for OMOs was expressed as a target for the federal funds rate—an overnight, unsecured rate in the market for reserve balances. The target rate was achieved through permanent and temporary OMOs that sought to adjust the supply of reserve balances in the banking system to a level that was expected to equal the estimated level of demand for reserve balances at the FOMC’s target rate. The Desk’s permanent additions to the supply of reserve balances were designed to fall somewhat short of the total demand, creating a “structural deficiency” in the supply of reserves. The Desk then conducted daily fine-tuning operations to temporarily add reserve balances to get to the desired level. These daily operations represented a marginal adjustment to the aggregate supply of reserves, largely in response to the exogenous impact of transitory changes in other Fed liabilities such as currency in circulation and the level of the U.S. Treasury’s account balance at the Fed.”

“This system functioned with a relatively low level of reserve balances. The Desk was able to reliably achieve the FOMC’s policy directive under this implementation framework. The effective federal funds rate—the average rate prevailing in the brokered federal funds market each day—routinely hit the FOMC’s target rate, generating a high degree of confidence.”

The post-crisis changes in operating procedures

“With the federal funds rate and other short-term interest rates effectively at the zero lower bound, the FOMC’s operating objective for OMOs was expanded to include adjustments in the size and composition of the Federal Reserve’s securities portfolio. In particular, the FOMC initiated large-scale asset purchases (LSAPs) of agency mortgage-backed securities (MBS), agency debt, and later longer-term Treasury securities, in order to put downward pressure on longer-term interest rates, support mortgage markets, and help make broader financial conditions more accommodative. The expansion of the domestic securities portfolio that resulted from LSAPs vastly increased the supply of reserve balances in the system.”

“Central bank purchases of longer-term bonds reduce the stock of such securities held by private investors. Accordingly, the purchases remove duration risk—and in the case of agency MBS, prepayment risk—from the private sector, which drives term and other risk premiums on those assets lower than they would otherwise be…The term premium effect of the Fed’s purchases should continue to influence financial conditions as long as the assets remain in the SOMA portfolio, although the size of the effect will diminish over time as the risk associated with the portfolio diminishes…The SOMA Treasury portfolio currently has an average duration of about 7.5 years, compared with a pre-crisis level of about 2.6 years. Meanwhile, the duration risk of the entire domestic securities portfolio, including agency MBS and agency debt as well as Treasury securities, is equivalent to about USD2.9 trillion in 10-year Treasury securities.”

“The current purchase program appears to be nearing its completion…Should this course come to pass, the domestic securities portfolio will peak at a par value of about USD4.2 trillion—more than a five-fold increase since the start of the financial crisis in August 2007. The composition of the portfolio will also remain more complex. Formerly composed entirely of Treasury securities, the domestic portfolio is now only 60 percent Treasury securities, with the remainder held in agency MBS (and a small amount of agency debt securities).”

The implication for normalization” of Fed policy

“The Committee has been deliberating how it should proceed to remove policy accommodation (often called ‘normalization’)…Although the specific timing of this is not yet known, it’s certain that the level of reserve balances in the banking system will be very high. Assuming no other liabilities are issued, there would be about USD2.9 trillion in reserves—mostly in excess reserves…The relatively long maturity structure of the SOMA portfolio means that the level of reserve balances in the U.S. banking system will decline only slowly through passive means, absent any asset sales.”

“In itself, an elevated level of reserve balances need not impede the FOMC’s ability to effectively raise the level of short-term interest rates because of the ability to pay interest on excess reserves.”

“The Committee released a revised set of normalization principles…According to the principles, the Committee will adjust the level of monetary accommodation primarily by utilizing policy tools to influence the level of short-term interest rates—in the first instance, using tools with rates directly administered by the Fed. Tools that can immobilize or drain large levels of reserves to tighten control over the federal funds rate also remain available. However, the principles do not envision that active adjustments to the SOMA portfolio will play a featured role.”

“Specifically, the FOMC indicated that the federal funds rate will continue to play a central role in the Fed’s operating framework and communications during normalization, and that it will raise the target range for the federal funds rate when economic conditions warrant a less accommodative monetary policy stance. Adjustments in the interest rate that the Fed pays to depository institutions on excess reserve balances—that is, the IOER rate—will be the primary tool to move the federal funds rate into the target range.”

“The Committee also indicated that an overnight reverse repurchase agreement (ON RRP) facility and other supplementary tools will be used, as needed, to help control the level of the federal funds rate.  An ON RRP facility will supplement the primary role of IOER in controlling the federal funds rate by providing an alternative safe, overnight asset for money market investors…Conducting ON RRPs for same-day settlement with a broad range of counterparties—including primary dealers, money funds, government-sponsored enterprises, and banks—allows the Federal Reserve to provide a safe, liquid investment to a wider range of money market participants than those able to earn IOER, and thus expands the universe of counterparties that should generally be unwilling to lend at rates below those available through the Federal Reserve.”

“In addition, the Federal Reserve Board has been testing a facility through which it offers term deposits to credentialed depository institutions. Term Deposit Facility (TDF)transactions could be used to temporarily reduce the quantity of reserve balances.  An eight-week series of tests this summer explored how demand for term deposits responds to variations in the maximum award limits and rates. Higher offered rates attracted greater use, both in terms of the number of participants and the total dollar volume demanded.”


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