Fed poised to finally lift rates — it hopes
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The Federal Reserve is expected to announce a rate hike soon. USA TODAY financial reporter Paul Davidson tells us what it could mean for the economy. USA TODAY
The Federal Reserve is poised to end the suspense Wednesday, raising interest rates first time in nearly a decade and closing an extraordinary era of easy money spawned by the 2008 financial crisis.
Now, a potentially more unsettling drama is set to begin: Will rates actually climb as the Fed intends?
Banks and other financial institutions are so awash in Fed money that the central bank has been forced to deploy new tools that economists say are likely to be less precise than previous methods and could roil jittery markets.
“We should anticipate some volatility in (the Fed’s benchmark rate),” says Paul Ashworth, chief economist of Capital Economics.
Historically, the Fed has increased its federal funds rate – what banks charge each other for overnight loans — by selling securities to banks or brokers to shrink their cash reserves and raise the cost to borrow money.
But banks are flush with $ 2.5 trillion in excess reserves since the Fed bought massive amounts of bonds after the financial crisis and recession to lower interest rates and stimulate the economy. As a result, the Fed cannot control the fed funds rate with its relatively small securities purchases.
Instead, it has set the funds rate in recent years by paying banks 0.25% in interest to park their excess reserves at the Fed. Banks should not have any incentive to lend at a rate below a risk-free deposit.
But since other entities, such as money market mutual funds, can’t earn interest on their excess cash, the Fed also has introduced reverse repurchase agreements to put a floor under the rates they offer. With “reverse repos,” a money fund, for example, buys a risk-free security from the Fed for a day at 0.05% interest. It should have no reason to lend below that rate.
The fed funds rate has hovered between zero and 0.25% since 2008, and the Fed aims to raise it to 0.25% to 0.5% by manipulating the rates for both reverse repos and interest on excess reserves.
Complicating the picture is that the Fed has set a $ 300 billion daily cap on reverse repos because it’s worried that investment firms could flock to them during financial turmoil, further discouraging lending and worsening a crisis.
As a result, some firms may not be able to access them at times and so could make loans that undercut the Fed’s target range, especially at the end of quarters when many companies shore up their books with liquid assets.
Adding to the uncertainty is a shortage of repos in the marketplace after many banks shed them to meet financial reform mandates, says Kathy Bostjancic, head of U.S. macro investor services for Oxford Economics. That has pushed down their interest rates and could make it tougher for the Fed to hoist rates, especially if there are limits on its reverse repo program.
“There is the potential for heightened volatility and dislocations in the repo and money markets to spill over to broader global financial markets,” Bostjancic wrote to clients. “Among the worst outcomes is…the Fed does not successfully lift” its key rate.
The Fed has said it’s ready to increase the reverse repo limit, especially initially to ensure a smooth rate liftoff, and take other steps to raise rates, such as offering banks higher, longer-term deposit rates.
“The question is how long it would take them to get control of the funds rate and what measures are they forced to take,” Bostjancic says.
Ashworth says any volatility is likely to be temporary. He notes several short-term rates already have moved higher in anticipation of the Fed’s big move.
After all, it’s largely the Fed’s intent to adjust rates that moves markets. “There’s some uncertainty,” says investment strategist Anthony Valeri of LPL Financial. “I don’t see it as a big risk.”
Paul Davidson on Twitter: @PDavidsonusat.
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