It’s been widely publicized that Federal Reserve Chairman Jerome Powell has come under pressure from the White House to pause rate hikes for fear of straining the economy. More recently, there have been allegations that balance sheet reduction is in part to blame for the volatility that shook markets in December.
At the same time, an issue that has received far less attention is also having an impact on the Fed’s operations. In the years since the Great Recession, the Fed has changed its framework for controlling the fed funds rate (FFR). And now this little-understood change in the mechanism for setting rates—from a “channel system” to a “subfloor system”—may be due for yet another change. The question is whether current transmission mechanisms are effective and if they are sustainable.
Given the recent speculation and potential impact of policy changes going forward, this blog post looks at how the subfloor system compares to the channel system in adjusting short-term interest rates, what part the balance sheet plays, how the Fed plans to move forward, and what that all may mean for institutional cash investors.
How The Fed Moved From the Channel System to the Subfloor System
Prior to the recession, the Federal Reserve used what was called a channel system to conduct monetary policy. The Federal Reserve targeted the FFR through a channel, with the discount rate as the top bound and the interest rate on excess reserves (IOER) as the lower bound at zero. The thinking was that no bank would lend at a lower interest rate than it could receive from the Fed, and no bank would borrow from a bank when it could pay a lower interest rate to the Fed.
Following the recession, however, excess reserves began earning interest. Given a non-zero IOER and a large amount of reserves, the Fed switched from the channel system to the floor system. By controlling the IOER alone, the Fed could control the FFR. Assuming the FFR was lower than the IOER, banks could make a profit by borrowing at the former rate and depositing at the Fed to earn the higher IOER. Placing an increasing volume of excess reserves with the Fed would reduce the supply of loanable funds in the interbank market, driving up the FFR. Once the FFR was higher than the IOER, banks would be incentivized to lend at the FFR. And with the extra supply of funds, the FFR would fall.
However, following the switch between systems, the FFR was consistently lower than the IOER by 5 to 20 basis points. This became a concern to the Fed when considering its potential consequences as interest rates rose again. To combat this problem, the Fed decided to adopt a subfloor. ON-RRPs (overnight reverse repurchase agreements) would set the subfloor, while the IOER would act as the top floor (an effective ceiling on the FFR).
Since the implementation of the subfloor system, the Fed has maintained this policy but has had to address some issues along the way. The subfloor system was effective in controlling the FFR until June of 2018, when it began climbing toward the higher end of the range between the subfloor and the floor. In order to push the rate down, the Fed hiked the IOER by 5 basis points less than it hiked the FFR. Despite the adjustment, the rate has continued to float higher within the range. This is likely because, after an increased supply of treasuries put upward pressure on shorter-term instruments’ yields, supply fell. Once supply fell, the FFR experienced upward pressure. In response to the Fed’s move of decoupling the IOER and FFR rate increases in June, Fed Chairman Powell said that the Fed would take the same policy action again if necessary.
How Does Balance Sheet Reduction Factor In?
At the same time, the Fed’s ongoing balance sheet reduction may also be having an impact on how it will set rates. The Federal Reserve Bank took two actions following the Great Recession of 2007 that would forever change the way monetary policy functioned. First, the FFR was lowered to zero to encourage business activity and consumer spending. Then, the Fed began large-scale asset purchases of longer-term securities, effectively injecting money into the economy to put downward pressure on long-term interest rates and further stimulate the economy. The balance sheet grew from less than $1 trillion prior to the implementation of the stimulus program to a peak of $4.5 trillion.
Since balance sheet reduction began in October of 2017, the Fed has let Treasuries and mortgage-backed securities roll off the balance sheet as they mature, most recently at a pace of $30 billion and $20 billion, respectively, per month. The impact of balance sheet reduction has been heavily debated. According to the Federal Reserve Bank of Boston, a $100 billion decrease in reserves increases the effective fed funds spread by 0.5 basis points and the overnight repurchase agreement spread by 2.1 basis points. The Fed will have to keep close watch on the impact of the balance sheet reduction, particularly since the FFR is now threatening to rise above the IOER. Further shrinking of the balance sheet will only increase this possibility, thereby threatening the viability of the Fed’s subfloor system.
Monetary Policy Going Forward
Following its most recent policy meeting, the Federal Open Market Committee (FOMC) announced that the target interest rate range will remain between 2.25% and 2.50%. Additionally, the Fed will continue reducing the size of its balance sheet, with Treasuries rolling off at $30 billion per month and mortgage-backed securities at $20 billion a month.
The FOMC is also prepared to adjust the projected size and composition of the balance sheet if more accommodative policy is needed. With respect to the rising FFR and adjustment of the IOER, Fed Chairman Jerome Powell said after the September 2018 policy meeting that it “is a problem we can address with our tools, and we’ll use them if we have to.” However, there is disagreement on whether the Fed can continue to lower the IOER relative to the FFR target range. Some have expressed doubt that this kind of action would do enough to solve the problem, going as far as to suggest that another change to the Fed’s framework may be the only feasible long-term solution.
What it Means for Institutional Cash Investors
What might these changes mean for institutional cash investors? Perhaps more than meets the eye. Looking beyond the headlines and examining some of the underlying causes of change may help corporate cash managers avoid risk while continuing to meet their yield objectives.
Treasury professionals are by necessity more interested in how changes in interest rates directly affect their portfolios than in the mechanism the Fed uses to move those rates. Even so, corporate cash managers should watch for how that mechanism might impact other variables, especially if it changes.
For instance, they may need to better understand how and why the ongoing reduction in the Fed’s balance sheet might be partly responsible for volatility in equity markets and, in turn, their portfolios. Correspondingly, if the Fed’s mechanism for setting rates impacts its management of the balance sheet reduction, cash managers might want to better understand how.
Equally important is the possibility the Fed will determine its current means of moving rates up or down needs to change. If or when it does, institutional cash managers should be on the lookout for ways those changes might impact the rates of various asset classes. Because even small unexpected movements in the timing or extent of rate changes can have significant impact on cash portfolios.