Federal Reserve’s new tactic

Last week Janet Yellen, chairman of the Federal Reserve (Fed), held a news conference after a two-day Federal Open Market Committee meeting.

As a result of this meeting, the Fed remained on its easy-money tack. Ms. Yellen repeated that any move in interest rates will be “data-dependent.”

Contrary to expectations, the Fed left key provisions in place rather than take tightening measures. The U.S. central bank is going to reduce its bond-buying program by $15 billion a month and indicated quantitative easing will end in October.

The Fed issued a statement: “The Committee continues to anticipate, based on its assessment of these factors (including unemployment and other labor indicators, household spending, and business fixed investment), that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee’s two percent longer-run goal, and provided that longer-term inflation expectations remain well anchored.”

The Fed plans on using overnight reverse repurchase agreements, repos, when it begins increasing rates from near zero percent next year as the economy strengthens. The Fed uses repos to absorb cash from money-market mutual funds and other nonbank financial institutions and pays interest in return. The interest rate the Fed sets on repos will gradually increase as the Fed raises rates. This rate is currently 0.05%.

The Fed indicated it would still use its benchmark federal-funds rate, an overnight rate on interbank lending, as its key rate for conveying where it wants short-term rates. This rate affects other borrowing costs including mortgages and business loans. The Fed expects the repo rate to assist in setting the lower range of the fed-funds-rate target.

There will be limits as to what degree the Fed will enter into reverse-repo trades. Economic analysts believe this could mean short-term interest rates could at times fall below the intended floor. The Fed acknowledges this is a risk but it doesn’t seem concerned. The Fed anticipates the federal funds rate may fluctuate within the target range and could occasionally even move outside of the range.

There are new limits capping the Fed’s total reverse-repo activity at $300 billion daily.

This is significantly above the average of about $120 billion this year, but a small portion of the $3 trillion of overall reserves in our financial system. It is anticipated that demand for repos will spike some days (i.e. at the end of the quarters) in a year.

There is a concern about periodic spikes above the cap causing volatility in short-term interest rates. This replaces the Fed’s practice of withdrawing small amounts of reserves (the money banks place at the central bank).

The Fed has flooded the banking system with reserves in responding to the financial down turn and recession.

The fed-funds rate paid to banks for reserves is going to be the key method for the near future. Increasing that rate should affect banks’ inclination to lend reserves and increase various short- and long-term rates.

 

Mary Ann Clark is a Realtor with Coldwell Banker at 177 West Putnam Avenue in Greenwich. Questions or comments may be emailed to [email protected]

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