On December 17th, 2015, the FOMC raised interest rates for the first time since the 2008 financial crisis.
To be sure, it had little choice. The Fed had been signalling an interest rate rise persistently for months, and had already disappointed markets twice by delaying rate rises in September and October. It had painted itself into the same corner as the ECB did over QE earlier in the year.
The ECB signalled for months that it was going to start QE, and backed off several times, to the disappointment of market participants. Eventually, ECB was forced to start QE for the simple reason that NOT doing so threatened financial stability, because markets had already priced it in.
So with the FOMC. Encouraged by broadly good economic data, and by the Fed’s approving noises, markets priced in a 25bps interest rate rise. The FOMC was all but obliged to act, simply to avoid sparking a market rout. It was yet another fine example of markets being willing to let the Fed guide them along the road that they were already travelling.
Since that small but oh-so-significant rate rise, the Fed Funds rate has obediently remained firmly within its new 25 to 50 bps corridor. Indeed, it has hovered persistently around the midpoint of the range. Given that the system is still awash with excess reserves and the Fed Funds rate therefore has little effect on bank lending, it is remarkable that the rate has stayed both elevated and stable. How has this been achieved?
Yesterday, the FT reported that the Fed absorbed $475bn of excess reserves through overnight reverse repo operations in its last monetary operation of 2015, a record amount. Overnight reverse repos allow certain non-bank financial institutions to place funds at the Fed overnight in return for USTs (yes, the ones bought in the Fed’s QE programs) and 25bps interest. The interest rate is no accident: it is the floor of the target Fed Funds rate range. These reverse repos provide competition for banks in the funding markets, forcing banks to offer higher interest rates on funds they lend to non-banks. The Fed said in December that it would make $2tn worth of USTs available as collateral for reverse repo transactions: it is actually needing to use considerably less to maintain the Fed Funds rate well above its floor.
But reverse repos are only half the story. The Fed also set the interest rate it pays on excess reserves (IOER) to the top of the Fed Funds target range. This pulls the funding rate upwards, since banks will not lend reserves to each other at less than the IOER rate.
So far, it appears that the combination of IOER and overnight reverse repos is an effective new way of controlling the Fed Funds rate and, by extension, the general level of commercial interest rates. To be sure, it is early days yet: this was only a very small, almost symbolic rate rise which was widely anticipated and largely priced in. Whether these new tools will remain so effective, especially if the FOMC makes more and, potentially, larger interest rate rises, remains to be seen.
But if they do remain effective, it raises an interesting question. If interest rates can still be used as the Fed’s principal monetary policy tool when there are excess reserves in the system, do we really need to drain those reserves? After all, excess reserves force banks to hold more safe liquid assets on their balance sheets, affording more protection against liquidity shortfalls and bank runs. And the securities held by the Fed give it additional flexibility in liquidity management.
It’s worth remembering that if full reserve banking were adopted, as many would like, the Fed’s balance sheet would need to be far larger than it is at present. I do not personally endorse full reserve banking, because I believe it would severely restrict lending, particularly to higher-risk borrowers such as small businesses, to the detriment of investment and growth. But the “just-in-time” liquidity management approach of the pre-crisis era is not without its problems, too. Regulators since the crisis have insisted that banks hold larger liquidity buffers than previously, and for banks, reserves are the best form of liquidity.
QE has conveniently helped to move the banking system towards a better reserved and more liquid norm. We should think carefully before throwing that away.