How the Federal Reserve Raises Interest Rates
In recent decades, monetary policy was translated into action primarily by three instruments: reserve requirements, the discount window, and security sales and purchases. These mechanisms allowed the Federal Reserve to control the cost and availability of reserves for financial institutions, creating a countercyclical force and an anti-inflationary environment. With the onset of the financial crisis and the central bank’s aggressive reduction of the federal fund rate, increasing excess reserves from $5 billion to more than $2.5 trillion in the process, it became clear that the previous means of adjusting the reserve supply had become infeasible. This has often been missed when discussing a possible return to positive real interest rates, as the assumption of boosting rates through security sales by the Federal Reserve no longer holds true.
The expansion of reserve balances has led to the creation of new instruments, most notably interest payments on excess reserves (IPER) and reverse repo facilities. The payment of interest on excess reserves raises the lower bound as it provides rate transition through arbitrage. This is driven by the fact that some market participants are not eligible for payments on excess reserves and therefore are willing to lend reserves at any rate above zero. In fact, since the introduction of these excess payments in 2008, the federal fund rate has been slightly below the IPER rate because banks are profiting from the spread between the rate at which they can borrow from nonbanks and what they are paid on excess reserves. So with this tool, the central bank can alter the federal funds rate without changing reserve balances.
In addition, the Fed has conducted operational readiness exercises on reverse repo facilities that allow for a temporary decrease of the reserve supply by selling securities with an agreement to repurchase them later. These transactions reduce overall available reserves, complementing the IPER’s effect on the federal fund rate. The Fed’s Open Market desk has engaged in operations of varying scale, reaching $405 billion for same-day transactions, to ensure its ability to carry out the FOMC’s monetary policy decisions. Those operations, however, will only play a supporting role, given the current $2.3 trillion excess-reserve balance and the concerns that would arise if these assets were held in perpetuity.
For these reasons, when the FOMC decides that it’s time to raise the interest rate, remember that there is more to it than just an announcement. Even though tests in recent years seem to support their utility, it is unclear how well the IBER’s arbitrage between banks and nonbanks, together with reverse repo operations, will work in a normalizing monetary environment. The main risk, however, lies in the fact that monetary policy’s effectiveness is based on the trust of financial institutions and having a range of movement for rates.
Despite the noise and criticism that predictably accompany its actions, the Fed retains the trust of the markets, but given the sheer size of its balance sheet, its policy options appear limited. Therefore, when the central bank finally tightens, it is not only signaling that the worst is over and the economy has embarked on a steady growth path, it is also starting to reclaim its tools.