Fed Adjusts How It Raises Short-Term Rates to Keep Them Anchored
By Katy Burne
The Federal Reserve on Wednesday tweaked the way it raises short-term interest rates to keep them from floating too high.
The change, announced after the conclusion of the Fed's two-day policy meeting, is aimed at better anchoring short-term rates that are surging, primarily because of increased Treasury bill issuance.
The Fed said it would raise its benchmark federal-funds rate -- the rate on overnight loans between banks -- by 0.25 percentage point to a range between 1.75% and 2%. The rate influences many other borrowing costs throughout the economy.
The Fed also said it would lift its so-called IOER rate -- which it pays on the reserves banks park at the central bank -- by 0.2 percentage point. This marks the first time since the Fed started raising rates in late 2015 that it isn't lifting both rates by the same amount.
The central bank has sought for years to keep the fed-funds rate within a quarter-point range, and until recently the rate generally has averaged near the middle of that band. But by the Fed's May 1-2 meeting, the rate had moved toward the upper bound of its target range, which was then between 1.5% and 1.75%, according to minutes of the meeting.
Until now, the Fed has set the IOER rate at the top of the range. By instead putting it 0.05 percentage point below that ceiling, officials hope to press down the effective fed-funds rate -- the daily weighted average -- closer to the center of the range.
Some traders wonder whether one nudge will be enough. The Fed is eager to ensure that increases to the fed-funds rate continue to influence overall money-market rates in stable and predictable ways.
"If you don't get the fed [funds] effective [rate] right, it's harder to control everything else," said Priya Misra, global head of rates strategy at TD Securities, a broker dealer.
Fed officials at their May meeting agreed that "additional technical adjustments to the IOER rate could become necessary over time," the minutes said.
Gyrations in short-term rates are familiar territory for the Fed. A few years ago it introduced a third rate, which it pays to banks on reverse-repurchase agreements, to prevent the fed-funds rate from slipping below the bottom of its range.
The new change "could keep the effective federal funds rate well within the target range," the minutes said.
"It wouldn't take much of a blip in the market to get the fed [funds] effective [rate] to print outside the range, so this builds a buffer," said Seth Carpenter, chief U.S. economist at UBS, referring to the tweak in how IOER is set.
The difference between the effective fed-funds rate and IOER was generally between 0.10 and 0.18 percentage point between 2013 and 2015, and had narrowed to 0.08 point by the end of 2017. More recently, it had shrunk to 0.05 point, and in a May Fed poll dealers' median estimate was that the gap would fall to 0.02 point by 2019.
The Fed said in the minutes that the effective fed-funds rate had moved higher primarily because of increased Treasury bill issuance. The U.S. government sold a net $333 billion in bills in the first quarter alone, in part to fund the budget deficit and boost cash on hand. That was way up from the same quarter in 2017, when net bill issuance was negative -- the Treasury issued $61 billion less than the amount that matured.
The increased supply of bills has caused their prices to fall and their yields -- which move inversely -- to rise, causing ripple effects in short-term money markets.
Among them is a surge in the cost of overnight repurchase-agreement loans, or repos, used to finance purchases of Treasurys and other assets, said Peng Zhou, managing director at Sun Life Investment Management, which oversees $45 billion.
Such repos -- which are different from the Fed's reverse repos -- and Treasury bills now offer higher yields than before to the main lenders in the fed-funds market, the Federal Home Loan Banks, independently chartered financial institutions created by Congress to bolster U.S. housing finance. This means commercial banks have to pay more to borrow from the home loan banks, nudging the effective fed-funds rate higher.
At the same time, the commercial banks may be seeking to borrow more from the home loan banks at the end of the month.
Ms. Misra at TD said the additional demand could be why the fed-funds rate, which used to drop around 0.08 point at month's end when banks pared back holdings ahead of regulatory reporting, now drops just 0.01 point.
Write to Katy Burne at [email protected]
Corrections & Amplifications
This item was corrected at 1:35 p.m. ET on Thurs., June 14, 2018. Sun Life Investment Management oversees about $45 billion, not $59 billion.