Presenting The Mechanics Of "Liftoff" Or, How The Fed Actually Hikes Rates

Believe it or not, the Fed is likely to hike this month. 

Nobody really knows whether it’s too early and quite a few commentators now say it’s too late (waiting until they undershot NAIRU might have been a bad idea), but hike they must, if for no other reason than to prove that the normalization of monetary policy is still possible after seven years of Keynesian lunacy. 

So let’s say liftoff actually occurs. How is the rate hike transmitted? To the uninitiated, it might seem as though Janet Yellen snaps her fingers or twitches her nose and just like that, banks and money markets price in the 25bps.

But contrary to Haruhiko Kuroda's characterization of central bankers as fairy tale protagonists, it's not as simple as waving a magic wand and in the US, the whole show runs through Bill Dudley's Open Market Trading Desk at the New York Fed.

In reality, there's nothing magical about the process - it's just a function of carrying out reverse repos and hiking IOER (which, by the way, means the Fed will be paying out more even as its portfolio of securities pays a fixed coupon). For those curious to know exactly how it works, we present the following Q&A from Goldman.

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From Goldman

Q: First off, how did the Federal Reserve implement changes to the federal funds rate before the financial crisis?

A: Conducting monetary policy during the pre-crisis era was relatively simple. The FOMC set specific targets for the overnight federal funds rate, and the New York Fed’s Open Market Trading Desk ensured that the overnight rate traded close to target by engaging in repo and reverse-repo transactions such that the aggregate supply of banking reserves roughly matched prevailing reserve demand. Average excess reserve balances were far smaller during the pre-crisis era (generally ranging between $10-$15 billion during the five years before the crisis, not including banks’ vault cash), necessitating only small-scale open market operations to help set the effective federal funds rate.

Q: How will the Fed implement rate hikes with a large balance sheet?

A:This time around, the Fed will primarily rely upon two key tools to raise the federal funds rate: (1) Paying interest on excess reserves (IOER) deposited at the Fed, and (2) an overnight reverse repurchase facility (RRP). The IOER rate is expected to serve as a floor for lending rates between banks, while RRP is expected to serve as a floor for lending rates for other money market participants. Most observers expect that the effective federal funds rate—the weighted average rate in the federal funds market, and still the Fed’s official policy rate—will settle between the IOER and RRP rates.

Given some limitations to both IOER and the RRP facility, the Fed will employ both tools in conjunction. The IOER function is constrained by limited counterparty eligibility, which is restricted to depository institutions only – the Fed cannot remunerate overnight deposits of money market mutual funds (MMFs) or government-sponsored entities (GSEs). Furthermore, banks with access to IOER may find it uneconomical to engage in IOER arbitrage – borrowing funds at rates lower than IOER and subsequently depositing them at the Fed to earn IOER – given the costs associated with expanding their balance sheets to finance their reserves (costs include FDIC fees, capital surcharges, and liquidity requirements ). 

The RRP facility, which has 145 eligible counterparties spanning primary dealers, banks, MMFs, and GSEs, will act as a more complete floor for overnight rates. However, the RRP facility also faces its own limitations: Fed leadership has communicated its discomfort with the facility’s potential to attract too many flows during flight to quality episodes as financial intermediaries withhold wholesale funding and instead participate in RRP.

Besides IOER and RRP, the Fed will also have a term deposit facility (TDF) and term reverse repo facility (facilities with maturities longer than one business day) to drain reserves, although we expect these tools to be used heavily only around month- and quarter-end dates. During these times, financial intermediaries are incentivized to curtail short-term wholesale funding, and MMFs have tended to park their excess cash at the Fed’s RRP facility.

Q: Who determines the level of IOER and RRP rates, and when do they take effect?

A:Current legislation states that the Board of Governors maintains the right to determine IOER rates, while the entire Committee votes on the RRP facility rate. Nevertheless, we expect both rates to be considered and discussed among all participants during future FOMC meetings—and to be included in the post-FOMC meeting statement, as with changes in the discount rate.

Changes to IOER and the RRP facility will be implemented on the day following an announced rate hike, as stated in the Minutes of the July 2015 FOMC. Accordingly, on December 17 we expect IOER to be set to 50 bps and RRP to set at 25 bps.

Q: How do you expect rate hikes to impact other overnight funding rates?

A: We expect other key funding rates (federal funds, repo rates, and Eurodollar deposits ) to rise alongside federal funds, as the rate hikes’ intended tightening of overnight funding costs transmit across financial products. The presence of arbitrage should ensure that all overnight funding rates rise: counterparties eligible to receive one of either IOER and/or RRP will be incentivized to borrow reserves overnight at increasingly higher rates to earn the greater returns offered by the Fed’s IOER and RRP facility. Product-specific “frictions” (including collateralization requirements, credit risk, liquidity risk, etc.) will likely continue to drive a wedge between overnight interest rate products. Nevertheless, IOER should serve as a floor for lending between banks, and RRP as a floor for transactions between other money market participants (the RRP facility failed to serve as a firm floor during quarter-end testing episodes in late 2013 and 2014 when demand for the facility exceeded the cap and late-day trading dipped below RRP rates). Aside from technicalities around month- and quarter-end dates, other overnight rates – including the federal funds rate – should settle between IOER and RRP.

Q: What if overnight money market rates do not rise into the 25-50bps range after a hike?

A:The key risk to the Fed’s operating framework is that the agglomeration of IOER, RRP, TDFs and term RRPs fail to adequately absorb excess cash — either directly or by incentivizing market participants — and overnight rates fail to rise above the 25bp RRP floor. In the unlikely event that this occurs, the Fed has three main levers it can employ to ensure rates move up:

(1) Raise the cap on RRP facility:Should demand for RRP exceed its initial allotment size, we expect the Committee to raise the facility’s cap to meet demand at the 25bp rate. On an absolute basis, the upper bound for the facility would equal the roughly $2.5 trillion size of the Fed’s Treasury security holdings (which are eligible for RRP).

(2) Increase IOER: Given the Committee’s stated reluctance to create an excessively large RRP facility, Fed officials previously discussed the option of increasing IOER in the March 2015 Minutes, thereby widening the spread between IOER and RRP. A wider spread should simultaneously push rates higher while lowering demand for RRP. Indeed, testing results from the RRP facility to date have shown that higher repo rates did coincide with lower RRP usage (Exhibit 3).

(3) Conduct additional term draining operations: The Fed’s term deposit and term RRP facilities provide an alternative means for draining excess reserves on an ad-hoc basis, although we expect the Fed to deploy these tools primarily around month- and quarter-end dates.

Q: How do you expect the Fed to structure its RRP facility?

A:We expect the Fed to offer a fixed 25bp RRP rate with a $750bn aggregate cap–up from $300bn currently—and a $30 billion per-counterparty cap during the early stages of the hiking cycle. Changes to the RRP facility are likely to be announced by the New York Fed shortly after the release of the December FOMC statement. The cap is likely to remain elevated initially, as the Committee’s desire to set a firm floor on money market rates outweighs any concerns with elevated caps. Over time, the cap is likely to decline as policymakers grow more comfortable with the supply/demand dynamics of the facility and reserve balances shrink as portfolio runoff commences.

Q: Given the uncertainty associated with conducting monetary policy operations with large excess reserves, why doesn’t the Fed simply shrink its balance sheet?

A: Although the Fed has communicated its intention to reduce the size of its balance sheet over time and create a Treasury-only portfolio, we do not expect any actions to meet this intent any time soon. The Minutes of the July 2015 FOMC meeting indicated that “Participants generally favored continuing reinvestment during the early stages of normalization, initially using only increases in the target range for the federal funds rate to reduce monetary policy accommodation.” Fed officials have communicated their concerns that asset sales pose the risk of sending unintended hawkish policy signals, along with the potential to create unexpected financial market reactions. Accordingly, we do not expect any balance sheet normalization until mid-2017.