US Fed may need to update its interest rate guide

Written by Reuters | New York | Updated: May 19 2014, 14:42pm hrs
Janel YellenWith $2.5 trillion in reserves, the US Fed's ability to control that rate is much harder. (Reuters)
Interpreting US Federal Reserve policy is hard enough, but the central bank may need to dust off its How to guide to explain the nuts and bolts of new tools it will use when it finally starts to raise interest rates.

Traders and analysts were accustomed to just glancing at the traditional federal funds rate. But managing that rate was easier when the banking system had about $800 billion in excess cash. With $2.5 trillion in reserves, the Fed's ability to control that rate is much harder.

The Fed has to look elsewhere to mop up reserves easily without causing dislocations. Now it has the TDF, RRP and IOER. Or rather, the term deposit facility, reverse repurchase agreements and interest on excess reserves the three other programmes that the Fed has signalled it will use when it attempts to normalise interest rates.

If successful, the combination of all three, along with how the Fed controls the fed funds rate, will usher in a new policy regime instead of the ultra-loose one it has clung to for the last five years. But if this confuses investors, analysts fear the Fed could lose credibility and harm markets and the economy.

Most short-term market rates have been stuck in the single-digit to high-teen basis-point range since the Fed adopted its near-zero rate policy in December 2008.

Right now, they dont have an issue. They are just setting a range for the fed funds rate and how it moves around doesn't matter to them. But as they exit, they might want to have more precise control of the market," said Ethan Harris, chief economist at Bank of America Merrill Lynch in New York.

To make sure short-term rates hold up as it tightens, the Fed has ramped up testing of its "alphabet soup" programmes.

This will help the Fed sop up excess bank reserves, which analysts say is necessary because of the sheer volume of reserves and because longer-term tools cause less short-term disruptions in rates markets.

The IOER, which is currently at 0.25%, offers banks income on excess reserves held at the Fed. The effectiveness of this programme has been mitigated somewhat by the bank needing to hold capital against those reserves. Arguably, the most critical tool are RRPs or reverse repos.

The Fed has been paying 0.05% on its RRPs.

Money funds have $2.6 trillion in assets. Mortgage agency Fannie Mae had $14.1 billion in cash and $12.8 billion in fed funds and repos with banks at the end of March, while its sibling Freddie Mac held $10.6 billion in cash and $24.5 billion in repos.

Compared with the TDF, the reverse repo facility is a veteran of Fed operations. The Fed started talking about such a tool in July 2013, and is now using it regularly to drain excess cash from the banking system.

But with the mountainous task of "normalising" policy, the Fed might need to rummage through its cabinets for even more tools.