How Will the Fed Raise Rates?

Jon Hilsenrath has an interesting piece in today’s WSJ on what will happen when the Fed decides to raise interest rates. Traditionally, the Fed has adjusted their target for the Fed Funds rate, but as Richard Fisher, the top dog at the Dallas Fed recently said, “It is my opinion that the fed funds rate is not the right tool going forward.”

The Fed now pays interest on the reserves kept at the Fed, so that could be the new all-important rate. The hitch is that there’s now a lot of money in short-term money market funds that are outside the banking system. Here’s Hilsenrath:

To address that problem, the Fed is experimenting with another lever. It is conducting trades—called overnight reverse repurchase agreements—directly with nearly 100 money-market funds and other financial institutions. Through reverse repos the Fed pays interest to these nonbank entities.

In theory, the reverse repo rate and interest rate paid to banks on reserves could become the Fed’s new benchmark interest rates. Ms. Yellen in congressional testimony this month said both rates were part of the Fed’s tool kit.

She and others say they are confident that the Fed can tighten credit conditions when needed. But unresolved issues abound.
One worry: As Fed officials move toward a new system, trading in the fed funds market could dry up and make the fed funds rate unstable. That could unsettle $12 trillion worth of derivatives contracts called interest rate swaps that are linked to the fed funds rate, posing problems for people and institutions using these instruments to hedge or trade.

Another worry: If they make overnight reverse repo trades more appealing than bank reserves, they could drive activity in short-term lending markets away from banks and toward unregulated money funds.

Cullen Roche doesn’t think this will be a problem. I think QE will be all wrapped up by January 1, and we’ll have another six months after that until interest rates rise.

Market veterans like to laugh at the phrase “this time it’s different,” but truthfully, each time really is different.

Posted by on May 19th, 2014 at 11:01 am


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