How the Fed will raise interest rates

  How the Fed will raise interest rates

ON DECEMBER 16, the Federal Reserve will probably raise interest rates from the current corridor of 0-0.25%, where they have been for six years. The last time it lifted rates from an extended stint near zero was 1947. But this rise will be exceptional for more than ending zero rates. The Fed will also be using new monetary policy tools to make rates budge. How, then, will the Fed raise rates?
The interest rate the Fed tries to shift—the “federal funds rate”—is the rate banks charge each other for overnight loans. These loans are made because the Fed requires banks to hold a minimum amount of money in their accounts at the Fed each night. Banks with plentiful Fed balances lend to those in need, to help them make their quota. In the past, the Fed has moved the interest rate on these loans by buying and selling government debt. For instance, when the Fed sells a Treasury to a bank, it docks that bank’s account with the Fed (just as a bank might charge its customers by docking their current account). That makes money scarcer, but the banks must still meet their minimum balances. As a result, the price of overnight loans rises—and with it, the cost of credit for the economy at large.
The principle is simple: because the Fed controls the supply of reserves, it can also control their price. But this mechanism is not available any more. That is because since 2008, under its policy known as quantitative easing, the Fed has bought $3.8 trillion worth of Treasuries and other securities in attempt to stimulate the economy. In doing so, it created huge pools of new money, so that today banks are awash with reserves. To push up interest rates, the Fed would need to unwind all these purchases—something it does not want to do until rates are higher. What, then, can it do? It currently uses two tools to peg rates between 0 and 0.25%. One is the interest rate it pays on funds banks park at the Fed in excess of what is required. This is known as the interest rate on excess reserves (IOER). No bank should want to lend at lower than IOER, because it is less risky simply to park cash at the Fed. However, some non-banks, such as money market funds, who do not have accounts with the Fed, have been willing to lend for less than IOER. So the IOER is not a hard floor for interest rates. In fact, it is currently set at 0.25%—the supposed ceiling. When raised, it should act like a “magnet” and pull rates up, say officials.
The second tool is known as the overnight reverse repurchase agreement. This is less confusing than it sounds; the Fed sells securities to investors, and agrees to buy them back later. In effect, the Fed borrows from investors, posting the security as collateral. This also puts a floor under interest rates; why would an investor lend to a bank for less than what the Fed—which is government-backed—is willing to pay? Crucially, the investors who can participate in overnight reverse-repos are the same ones who might otherwise undercut the IOER. When the Fed lifts both the IOER rate and the reverse-repo rate, the federal funds rate should budge too. Will it work? The Fed has been testing these tools since September 2013, and is confident as a result. The theory seems solid, too. But no-one will know for sure until December 16th, probably.