Interest on Reserves to be Raised

Interest on reserves held by the Federal Reserve is the new buzzword to watch for clues in changes in interest rates in the immediate future. This implies that the focus for traders in the money markets will shift away from the Fed funds rate (the rate banks charge one another for overnight loans in the interbank market). Instead, the level of the interest rate paid on reserves at the Fed will be the new kingmaker.

The ability to pay interest on excess reserve bank deposits with the Fed is an important new tool that Congress authorized the Fed to do in 2008. It will play a lead role when the time ultimately comes to tighten monetary policy. Market participants will have to keep a much closer look at this and other new mechanisms available to the Fed in normalizing the financial markets

This is the biggest challenge facing the Fed: To assure markets that efforts to bring short term interest rates back to normal is not aimed at raising interest rates in general and by doing so tip the economy back into recession. With the official unemployment rate at 10% - but the broader measure around 17% - the Fed will face unprecedented political pressure if this tightrope is overstepped.

According to the latest statement by the Federal Open Market Committee economic conditions warrant exceptionally low levels of the federal funds rate for an extended period.

The action taken by the Fed to improve liquidity in the banking system is coming to an end on March 8 with the final auction of discount window funds started at the time of the financial meltdown. This signals an important change in stance from the Fed for future action. Only two programs remain for multiple borrowers. The term asset-backed securities loan facility closes on March 31 and the newly issued loans backed by commercial mortgage-backed securities on June 30

It can therefore be expected that – for the first time - the Fed will start paying interest on excess reserves in the immediate future. This will put upward pressure on all short term interest rates in the banking sector. It does, however, not imply immediate higher interest rates for consumers or businesses.

The payment of interest on excess reserves by the Fed will follow an increase in the discount rate of 25 basis points on February 19 in response to improved functioning of the financial markets as the need for extraordinary assistance has diminished substantially.

To see whether this action by the Fed is successful or not, market participants will have to watch closely how the yield curve changes after the event. (The yield curve is a graphical presentation of the level of interest rates for maturities ranging from short to long term, see graph). First prize for the Fed will be for longer term interest rates to fall (prices to rise) on such an announcement.

Another reason why there is no pressure on longer term interest rates to rise is inflation expectations. According to the monetary policy report to Congress delivered by the Board of Governors of the Federal Reserve System on February 24, inflation expectations over the longer term is firmly anchored.

The effect of paying interest rates on reserves imply that banks will demand higher returns on overnight loans in the federal funds market, according to Janet Yelen, President and CEO of the Federal Reserve Bank of San Francisco. In a speech made on February 22, she concludes that an increase in the interest rate paid on reserves would raise the fed funds rate and tighten financial conditions more generally. But to ensure that market participants do not ‘overshoot’ the fed funds target rate, the Fed has developed other technical tools to keep the fed funds rate at or near the Fed’s preferred level.

These possible actions by the Fed are aimed at improving control of financial conditions to ensure a tighter relationship between the interest rates paid on reserves and other short term interest rates. The emergency lending programs of the Fed caused its balance sheet to swell from approximately $800 billion to over $2.2 trillion. The actions to bring the balance sheet back under control include the expansion of reverse repurchase agreements to absorb large quantities of reserves from the banking sector as well as other methods still yet unseen.