FOMC July 31: A Post-Mortem

On July 31 the Fed announced a 25 basis point cut in both its target band for the federal funds rate and in its rate of interest on excess reserves (IOER).  The new IOER would be 2.15%.  Media coverage widely parroted the statement that the Fed had lowered interest rates for the first time since the onset of the Great Recession.  The media continues to emphasize Fed statements about the federal funds rate, despite the reality that what matters most in the current monetary policy environment is the IOER.  That rate was actually cut, very slightly, by 5 basis points on May 1.

The ongoing reality is that market interest rates have been falling since late November of 2018, despite Fed actions, and despite the Fed’s increase in the federal funds rate in December 2018.   On December 20 2018, when the Fed raised the federal funds rate target range by 25 basis points and raised the IOER by 20 basis points, market interest rates on Treasury securities increased only slightly, and not uniformly across different maturities.  The largest increase was a 7 basis point increase in the rate on one-month T-bills.  The rate on 3-month T-bills actually fell 1 basis point.  If we take a longer view, over the period from November 30 to December 31, rates rose on treasuries maturing in less than one year, with the one-month T-bill rate rising 13 basis points, while rates actually fell on securities maturing in one year or more.  The largest decline was 37 basis points on the 3 year Treasury securities.  So while the Fed was raising its overnight rates, most interest rates were declining, including the influential ten year Treasury rate, which fell by 32 basis points.  This just underscores the point that the Fed is not able to unilaterally lower market interest rates.  The Fed is able to lower the rate it pays on excess reserves, an administered rate, and it has tight control on the overnight federal funds rate.  All other rates move as the market dictates, and not always in line with Fed actions.

If anything about the FOMC’s most recent announcement was surprising, it was that the reduction in the IOER was only 25 basis points.  This new interest rate paid on bank reserves, 2.15%, still leaves the return to banks for holding excess reserves at or above the immediate close substitute, Treasury securities.  In fact, on July 31 all Treasury securities with maturities of less than 20 years had interest rates below 2.15%. The Fed’s cut still leaves banks with an incentive to park their ‘safe’ investment funds in reserve accounts instead of in Treasury securities.  Bank holdings of excess reserves have been rising, and the latest Fed action may be insufficient to change this.

The Fed’s cut of 25 basis points on Wednesday was not matched by market interest rate movements, although Treasury rates generally declined on Thursday.  The largest move was in the middle of the term structure.  There was a 17 basis point decline in 3 year Treasuries, a 16 basis point decline in 2 year Treasuries, and a 15 basis point decline in 7 year Treasuries.  Short rates fell much less, and the 1-month rate actually increased by 10 basis points.  At the far end of the term structure, 30 year Treasury rates fell by 9 basis points.  The 1-month Treasury rate on Thursday was now a scant 1 basis point above the IOER.  At week’s end the IOER remained above the interest rate on Treasuries with maturities of 3 months or more, and ten years or less.    

The effect of rising bank excess reserves on the money supply will be mitigated by another decision made at the July meeting - to halt the Fed’s asset reduction program. Since the first of this year the Fed has reduced its assets by $240 billion. During that same period, bank holdings of excess reserves fell by only $59 billion, so the Fed’s support of the money supply has been significantly reduced.  A growing economy needs an expanding money supply, and even without the headwinds of the Fed’s asset reduction program, the economy needs banks to put their excess reserves to work in supporting money supply growth.

Since May 1, Fed holdings of securities fell by $116.6 billion, essentially reducing bank reserves by that same amount. During that same period, bank holdings of excess reserves actually rose by $46.3 billion. This increase in excess reserves occurs when banks fail to replace maturing assets and instead hold those funds as interest-earning reserves. This combination of Fed asset reductions and bank additions to excess reserves resulted in a $163 billion, 6.8%, reduction in Fed net assets, a quantity that supports the nation’s money supply.

In the current policy environment, a primary driver of monetary policy is the IOER relative to the earnings available to banks on other potential assets.  The Fed – and more specifically the Board of Governors – chose to only cut the IOER at the July meeting by 25 basis points, despite the continued broad decline in market interest rates on assets that banks regard as close substitutes for reserves.  The reality is that unless the downward trend in these market interest rates changes, the Fed will remain under pressure to significantly reduce the IOER.

Posted: August 05, 2019 by Dennis W. Jansen, Thomas R. Saving