Since September, when the Federal Reserve reduced the top of the target range for the Fed Funds rate from 2.25% to 2.00%, a reduction 25 basis points, and reduced the interest rate paid on bank reserve balances from 2.1% to 1.8%, a cut of 30 basis points, market interest rates have continued to fall. As a result, the interest rate paid to banks to hold reserves is again above the interest rate on all Treasuries with maturities of less than 20 years. The very fact that market interest rates are changing without Fed action begs the question of whether the Fed can even influence the direction of change in market interest rates, much less control these rates more precisely. Many choose to ignore this relationship between the primary policy rate set by the Fed – the interest rate on excess reserves (IOER) – and the nation’s money supply, but this is a mistake. It is this relationship that makes the Fed’s decision on IOER, and its closely related decision on the upper bound Federal Funds Rate target, extremely important.
A Brief Post-QE History of Interest Rates and Fed Policy
As we have said before, the Fed is an interest rate follower, not a leader. The one interest rate the Fed has complete control of is the IOER, as it is an administered rate that is set by the Fed. The Fed has had reasonably good control of the Federal Funds rate, although it had problems keeping this rate below the announced target upper bound in September, and it has had more trouble keeping the Secured Overnight Funding Rate (SOFR) at or below the Federal Funds rate upper bound target.
To see that the Fed is an interest rate follower, consider the figure below. It shows the paths of 3-month, 1-year and 10-year treasuries along with the Fed’s upper bound target for the Fed Funds market, and the interest rate on reserves, the IOER. The graph shows that 1-year rates rose prior to Fed actions, and suggests that the Fed was not so much determining interest rates as following their upward trend.
From the beginning of 2015 through 2017, the IOER and the target Fed Funds rate upper limit were essentially identical, and they tracked the 90-day and 1-year treasury rates with a lag. Every time the 90-day and 1-year rates rose, these increases were followed by the Fed increasing the IOER and the Fed Funds upper bound. In mid-2017, the rate of increase in both the 90-day and 1-year rates accelerated, and the Fed followed by changing the IOER (and the Fed Funds upper target) at every FOMC meeting. Until October of 2018, the Fed’s increases in the IOER lagged the magnitude of the increases in both the 90-day and the 1-year rate. In fact, by this time the 90-day rate, which had been consistently below the IOER, rose above the IOER. Then in June 2018, the Fed moved to separate the IOER from the Fed Funds upper target by 5 basis points, so the IOER was ever so slightly below the Fed Funds upper bound target. The difference between the Fed Funds upper target and the IOER has been increased with each reduction in the Fed Funds upper target and is now 20 basis points.
Market interest rates began falling on 3-month and longer-term treasuries in November 2018. Despite these falling market interest rates, the Fed decided to raise the IOER again in December 2018, and it also moved to further separate the IOER and Federal Funds upper target, from 5 to 10 basis points. Did the Fed’s actions increase market interest rates? Clearly not, as market interest rates continued their decline, seemingly unabated. In fact, market interest rates have been declining ever since.
In September, with market interest rates continuing to fall, the Fed cut the IOER by 30 basis points to 1.8%, and also cut the Fed Funds upper target by 25 basis points. This action finally resulted in an IOER that was below the 3-month and 1-year Treasuries. But this situation did not last. Market rates continued to decline, and this continuing fall has erased the small advantage that market rates had to the IOER. In fact, the following figure shows that as of October 23, the IOER is 16 basis points above the 3-month rate, 22 basis points above the 1-year rate and, amazingly, 3 basis points above the 10-year Treasury rate!
Another interesting development is the interest rate inversion that occurred in May, when the interest rates on short securities began to exceed the 10-year Treasury rate. This inversion is apparent in the figure above. Perhaps importantly, an interest rate inversion preceded the last three recessions. While the inversion has now disappeared, that disappearance is no indication that the implications of the inversion should be ignored. In fact the inversions that occurred preceding the last three recessions were all reversed well before those recessions began.
There is no strong consensus regarding the causality of interest rate inversions to recessions. Indeed, the inversion may be better thought of as indicating market participants’ expectations of a coming slowdown in growth rather than as some sort of direct cause of a future recession. But be that as it may, concern over future slow growth would seem to suggest an expansionary monetary policy is in order, which requires putting additional reserves in circulation.
Importantly the Fed now has at its disposal the tool to almost directly affect the money supply, the IOER. The combination of this rate and market rates of interest affect the banking system’s willingness to hold excess reserves. Reducing excess reserves when market interest rates exceed the IOER directly affect the banking system’s investments in the economy and convert excess reserves into required reserves and increase the money supply.
What Should the Fed Do in October?
The press and the futures market both expect a reduction in the Federal Funds upper target of 25 basis points at the October FOMC meeting. This would almost certainly be accompanied by a reduction in the IOER of 25 basis points. If this happens, the IOER would be set at 1.55%. Compared to market interest rates on October 22, this new level of the IOER would then be below all the rates at all Treasury maturities, albeit barely below for some maturities. Banks would finally get a higher interest rate by buying Treasuries with funds currently held as reserves. If the Fed wants banks to reduce excess reserves and get these reductions into circulation, it must again reduce the IOER. We would strongly recommend at least a decline in the IOER matching the 30 basis point decline achieved in the September FOMC meeting.