Fed’s Mission to Control Benchmark Rate May Spur Another Tweak

(Bloomberg) -- The benchmark interest rate that the Federal Reserve focuses on controlling to implement monetary policy has moved closer to the lower bound of its target range, increasing the prospect that the central bank will adjust one of its associated tools later this month.

The effective fed funds rate has been moving lower relative to the band since the Fed embarked on a series of repurchase-agreement operations and Treasury-bill buying to quell funding-market turmoil. Upheaval in September briefly saw fed funds rise above the upper bound of the range, but the measures to make more cash available over the turn of the year helped bring it down.

The effective fed funds rate fell to 1.54% on Friday from 1.55% a day earlier, according to New York Fed data released Monday. That put the rate just four basis points above the lower extremity of the Fed’s goal of 1.50% to 1.75%, the smallest such gap since the central bank began targeting a range rather than a single rate more than a decade ago.

“On the margin it raises the likelihood of some action, but it is yet to be determined,” said Credit Suisse (SIX:CSGN) strategist Jonathan Cohn.

When the fed funds rate strays, it can be a signal that the Fed doesn’t have strong control over its main tool for implementing monetary policy, a concern for central banks. The drift toward the lower end of the band has some observers speculating that the Fed might seek to lift the interest on excess reserves rate to help buoy it -- in effect undoing one of its prior tweaks in the opposite direction.

IOER, which is the rate that banks earn when they park funds at the Fed beyond their reserve requirements, is one tool that policy makers can use to tinker with rates. And while it doesn’t necessarily act as either a hard cap or a floor, it has been used to help steer the fed funds rate.

It has previously adjusted where that benchmark stands relative to the overall range to help prevent the effective rate from drifting too high within the band. The most recent occasion was in the wake of September’s turbulence, when it reduced IOER by five basis points relative to the range -- lowering it by 30 basis points rather than the 25 basis point reduction it made to the main range. It has also tweaked IOER on other occasions, including at meetings without monetary policy moves.

This time around, the effective fed funds rate is actually below IOER -- something that hasn’t happened since 2018 -- but a boost to the excess reserves rate could nonetheless help exert upward pressure on fed funds.

Any such move wouldn’t mark a change in the Fed’s broader monetary settings, as deciding on the overall target range is a separate question for policy makers. Bets in the interest-rate market continue to see the next move in the policy range as being down, although there is less than one quarter-point cut fully priced in for this year.

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Minutes from the December Federal Open Market Committee meeting showed that officials discussed that it may be appropriate at some point to lift IOER and the rate on its facility for overnight reverse repurchase agreements to move the effective rate closer to the target range.

Strategists have said there are other ways policy makers could nudge the fed funds rate higher. This includes tweaking the size or rate on the central bank’s overnight and term repo offerings. Those changes could come as early as Tuesday when the schedule for the next round of operations is expected to be released.

Jefferies money-market economist Thomas Simons said even with the one-day drop in the effective rate, it’s still too early to know whether the Fed will adjust IOER at its Jan. 29 meeting. Simons said there’s a chance fed funds sets at 1.56% later in the week due to potential adjustments in the repo operations and Wednesday’s mid-month settlement of the U.S. Treasury’s coupon auctions.

“There’s a lot of different levers the Fed could pull that would better affect the effective rate and they could do that before the meeting,” he said.