In addition to the hawkish discussion on timing of future rate hikes ("soon"), offset by the Fed's dovish admission it is willing to tolerate a "modest" inflation overshoot, coupled with the FOMC's thoughts on the shape of the yield curve, and the potential change to forward guidance, an interesting development and novel development in today's FOMC minutes was the discussion of an imminent adjustment that the Fed pays on Excess Reserves.
Currently at 1.75%, and referencing roughly $1.9 trillion in Excess Reserves, the Interest on Excess Reserves (or IOER) was prominently featured in a presentation by Simon Potter discussing the "technical realignment" of the IOER rate relative to the top of the range for the fed funds rates. This is the key excerpt:
The deputy manager then discussed the possibility of a small technical realignment of the IOER rate relative to the top of the target range for the federal funds rate. Since the target range was established in December 2008, the IOER rate has been set at the top of the target range to help keep the effective federal funds rate within the range. Lately the spread of the IOER rate over the effective federal funds rate had narrowed to only 5 basis points. A technical adjustment of the IOER rate to a level 5 basis points below the top of the target range could keep the effective federal funds rate well within the target range. This could be accomplished by implementing a 20 basis point increase in the IOER rate at a time when the Committee raised the target range for the federal funds rate by 25 basis points. Alternatively, the IOER rate could be lowered 5 basis points at a meeting in which the Committee left the target range for the federal funds rate unchanged.
In their discussion of this issue, participants generally agreed that it could become appropriate to make a small technical adjustment in the Federal Reserve’s approach to implementing monetary policy by setting the IOER rate modestly below the top of the target range for the federal funds rate. Such an adjustment would be consistent with the Committee’s statement in the Policy Normalization Principles and Plans that it would be prepared to adjust the details of the approach to policy implementation during the period of normalization in light of economic and financial developments. Many participants judged that it would be useful to make such a technical adjustment sooner rather than later. Participants generally agreed that it would be desirable to make that adjustment at a time when the FOMC decided to increase the target range for the federal funds rate; that timing would simplify FOMC communications and emphasize that the IOER rate is a helpful tool for implementing the FOMC’s policy decisions but does not, in itself, convey the stance of policy. While additional technical adjustments in the IOER rate could become necessary over time, these were not expected to be frequent. A number of participants also suggested that, before too long, the Committee might want to further discuss how it can implement monetary policy most effectively and efficiently when the quantity of reserve balances reaches a level appreciably below that seen in recent years.
This is in line with a note from Goldman from late last week looking at the "implications of rising money market rates for the Fed's Balance Sheet reduction" which, as the FOMC Minutes above confirm, found that the effective fed funds rate (EFFR) has drifted further toward the top of the Fed’s target range between the overnight reverse repo (ON RRP) rate and interest on excess reserves (IOER); repo rates have risen close to or above IOER; and usage of the Fed’s reverse repo facility has dropped to nearly zero. This is shown in the chart below.
So what does the above mean in simple English?
Well, as the FOMC reminds us, the IOER rate has been set at the top of the target range since December 2008 to keep the effective fed funds rate within the range. And, as the chart above shows and as SocGen points out, during the normalization process, the effective funds rate has generally traded close to the middle of the range, but more recently, the spread of IOER to the effective rate has narrowed to 5 bps.
The Minutes noted that “In large part, this development seemed to reflect a firming in rates on repos that, in turn, had resulted from an increase in Treasury bill issuance and the associated higher demands for rep financing by dealers and others.” With the Fed continuing to normalize its balance sheet, a drop in reserves was likely to keep putting upward pressure on the effective funds rate relative to the IOER rate, a process which has also been observed recently in the blow out in the Libor-OIS spread.
So to tackle that problem, the FOMC noted that the IOER rate could be set to a level 5 bps below the top of the target range. Fed officials “generally agreed” with this approach, and “many” judged that “it would be useful to make such a technical adjustment sooner rather than later.” They also largely agreed that it would be best to make this adjustment at a time when the FOMC decided to increase the target range (i.e. hike), so it seems that this change will occur in June. Thus, when the Fed hikes the target range by 25 bps, IOER would be boosted by 20 bps.
Goldman agreed with this and in a note released on Wednesday afternoon, noted that "making the adjustment at a meeting when the FOMC decided to hike rates was viewed as a simpler alternative to communicate, adding that IOER “does not, in itself, convey the stance of policy.”
What does this mean in market terms? Well, shortly after the announcement, Libor-OIS widened by about 2.5bp led by a drop in the OIS component, as market participants repriced the size of future Fed rate hikes after the minutes according to Bloomberg, although there was little additional impact.
Commenting on the upcoming change to the IOER, Jefferies economists Ward McCarthy and Thomas Simons said that the "current state of affairs" doesn’t justify a "significant change in operating procedure, but the Committee is being prudent by having this discussion ahead of time." However, they noted that if fed funds is only 2-3bp below IOER by early June, it’s possible that the Fed would implement this policy at the June meeting.
Even then, "it might make more sense for the Fed to investigate the issues a little bit more and communicate these issues to the market before making a change."
Practically speaking, a 5bps drop in IOER will have a tiny impact on how much interest banks collect from the Fed on their "parked reserves", although since the drop will take place only on an uptick in Fed Funds, it will be more than offset by the 25 bps increase in underlying rates, making sure that banks continue to extract a generous risk-free coupon on their $1.9 trillion in Uncle Sam generosity courtesy of the Federal Reserve.