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Forget When the Fed Will Raise Rates, How Is Still Problematic

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(Bloomberg) -- For all the talk about when Federal Reserve policy makers are going to raise interest rates, they haven’t quite figured out how to do it.

The central bank has had trouble controlling near-term borrowing costs since the 2008 financial crisis and has been experimenting with ways to do so. While its main new tool has enabled the Fed to exert more influence over money-market rates in the past year, strategists from Barclays to Goldman Sachs Group say the program is too small to prevent rates from falling when officials want them to climb.

At issue is the Fed’s balance sheet, which has ballooned through its bond buying, leaving over $2 trillion in excess reserves in the banking system that may prove to be more difficult to siphon off than in the past. New methods are needed because the federal funds rate, long the central bank’s primary policy instrument, has ceased to be an effective means to guide short-term market rates.

“The likelihood that we are going to get through this without some form of accident is very small,” said James Camp, a fund manager at Eagle Asset Management in St. Petersburg, Florida, that has $31.2 billion in assets. “My concern is that the rate resetting higher is not very elegant and becomes sort of clumsy, with a series of fits and starts.”


Camp, along with money-market economists such as Lou Crandall of Wrightson ICAP LLC, says the Fed will need to more than triple the use of its main tool, known as the reverse-repo program, to at least $1 trillion from the current $300 billion per day limit.

The facility is intended to withdraw or neutralize cash outside the banking system. In an overnight reverse repo, the Fed borrows cash from counterparties using securities as collateral. The next day, it returns the cash plus interest to the lender and gets the securities back.

Even though the program should help, Fed officials are wary of an over-dependence on such facilities, seeing the risk that it may cause investors to avoid privately issued securities for the safety of Fed repos in times of turmoil.

“A large and persistent program could have unanticipated and adverse effects,” Fed Vice Chairman Stanley Fischer said Monday in New York. “In times of stress, demand for the safety and liquidity” provided by reverse repos could exacerbate market disruptions, he said.


As Fed staffers tinker with the exit apparatus, the policy- setting Federal Open Market Committee last week dropped a commitment to be “patient” before raising rates, opening the door to a rise as early as June. The market sees a move later in 2015, given officials also lowered their estimates for the path of the funds rate over coming years.

In the past, the Fed increased the cost of overnight bank borrowing by raising the funds rate. The trillions of dollars in excess reserves that exist, compared with a few billion at the start of 2007, have obviated the need for banks to borrow daily and forced U.S. monetary authorities to come up with ways to influence market rates directly.

It has been evident since 2008, when the Fed gained the ability to pay interest on excess reserves, that the new rate wasn’t anchoring borrowing costs as envisioned. Government- sponsored agencies including regional Federal Home Loan Banks, primary providers of cash in the overnight market, aren’t able to receive such interest, which has enabled the funds rate to drift below IOER, now at 0.25%.


To make matters worse, widespread negative yields abroad, and heightened regulation on banks and money funds, have sapped the supply of safe short-term assets and buoyed demand. That further casts doubt on whether a tightening of policy will be smooth.

Strategists have expressed concern that, when the Fed starts to tighten policy by raising IOER, other market rates may not follow, leaving monetary conditions too accommodative. While banks receiving interest on surplus reserves have dimmed their desire to dump excess cash into the money markets, the funds rate has still consistently traded below the IOER. The reverse repo program thus far has helped provide a floor for the funds rate, which was 0.11% on Tuesday.

“Especially in the initial stage of a Fed liftoff, they are particularly concerned about fed funds sag, which is the effective slipping below the reverse repo rate,” said Joseph Abate, a strategist at Barclays in New York. “That would wind up hurting them in terms of credibility as it would look like the Fed is struggling to raise interest rates. Overall, you are going to get a lot more volatility in markets.”


Through reverse repos, the Fed aims to set a floor for short-term rates by temporarily pulling cash from the system with a wider array of counterparties that includes money-market mutual funds, its 22 primary dealers and government-sponsored agencies. Daily cash is removed through the transactions, at a fixed rate now at 0.05%, with Treasuries used as collateral.

The central bank envisions the fed funds effective rate, which averaged 0.12% this year, floating between the reverse repo rate and IOER. Last year the rate averaged 0.09%.

“It will take somewhat greater use of the Fed’s tools to get the funds rate into the middle of a 25 to 50 basis-point range than it does to keep it in the middle of a 0 to 25 range,” said Crandall, chief economist at Wrightson ICAP in Jersey City.

Along with the overnight reverse repos, the Fed plans to use similar agreements that extend beyond one day in times of high demand, such as quarter- and year-end -- as well as term deposits -- as non-traditional weapons to lift rates.

“At this point, I don’t the Fed could achieve their desired end goal of managing other short-term rates when they begin hiking,” said Tyler Tucci, a U.S. government bond strategist at Royal Bank of Scotland Group’s RBS Securities unit in Stamford, Connecticut, a primary dealer.

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