The Fed: A Loose Cannon With a Lit Fuse

It’s August. The first interest rate hike in eight years by the Federal Reserve could be just a month away.

While the topic of when the Fed will raise rates gets a lot of attention, that’s the easy part of the equation. All they have to do is make a motion to implement policy changes that will try to peg short-term interest rates to 0.50%. It’s a snap!

But then comes the hard part… figuring out the mechanics necessary to make that happen.

This used to be a simple task. The Fed would set the rate at which banks lent money to each other overnight, called the Fed Funds Rate (FFR).

This is essentially the interest rate upon which all other U.S. interest rates are based. Raise it, and others tend to follow. But now, thanks to a different Fed policy, the FFR is irrelevant. That could make raising rates difficult.

By printing trillions of dollars out of thin air, and using them to buy mortgage-backed securities and Treasury bonds from banks, the Fed left those banks with buckets of cash. Left to their own devices, banks might’ve tried to lend out the extra bucks, potentially driving inflation to the moon.

To stop such a trend before it started, the Fed created an incentive for the banks to hold their excess reserves at the central bank – paying them interest, literally known as “interest on excess reserves,” or IOER.

The Fed already institutes a minimum reserve requirement that banks must hold with them. But compared to the excess reserves, the minimum reserves seem like nothing.

Before the financial crisis, banks held the bare minimum required at the Fed. Those reserves amounted to roughly $60 billion at the end of 2007.

Today, the minimum required reserves are closer to $100 billion, but banks hold an additional $2.7 trillion in excess reserves at the Fed, on which they earn interest.

By encouraging banks to store these reserves, the Fed achieved its goal of keeping the cash out of the banking system and therefore the economy, but there was a side effect: Banks no longer needed to borrow money from each other. That means changing the Fed Funds Rate – its primary tool for raising interest rates – will have a limited effect, if any, on banks and the banking system.

So the Fed has to try something else. To this end, they’ve trotted out a new policy: reverse repurchase agreements, or reverse repos.

In this transaction, the Fed will sell some of the Treasury bonds it owns for one day, agreeing to buy them back the next day at a slightly higher price. The difference in price equates to whatever rate the Fed is trying to achieve for short-term interest rates.

The key is that the Fed will open its window to a broader group than just banks, allowing institutions such as money market funds, large pensions, etc. to lend the Fed cash overnight in exchange for Treasuries at a preset interest rate. The system has been in test mode for the last two years, with banks as the only counterparties and a cap on the transactions set at $300 billion.

There’s no guarantee the new approach will work.

Looking at the financial climate around the world as well as here in the U.S., there’s a lot of uncertainty in the markets.

The U.S. reported 2.3% growth in the second quarter, which is sluggish at best. Unfortunately, it’s also a massive jump from the 0.6% revised level of the first quarter, and well ahead of most every other developed nation on the planet.

In Japan, “Abenomics” are failing to stimulate growth. Exporters are benefiting from the devalued yen, but everyday workers and consumers are getting pinched. At the same time, China’s economy is slowing down, which is reverberating around the globe in the form of falling demand for commodities.

Then in the euro zone, investors of all sizes have to deal with the European Central Bank, which is buying more bonds each month than all the countries of the area issue. This leads to a supply and demand imbalance where investors can’t find enough bonds to own.

These factors lead to increased demand for safe, short-term fixed income products like U.S. Treasurys.

That means it’s entirely possible that the Fed’s allotment of bonds to the reverse repo market will be scooped up quickly, failing to meet the demands of the marketplace.

In this instance, buyers would be willing to pay more, accepting a lower interest rate than what the Fed was offering. This would drive the overnight rates below the Fed’s target.

To overcome this issue, the Fed will have to offer even more bonds in the repo market, possibly up to $1 trillion. It might work, but no one knows for sure. It’s never been done. That’s the heart of the problem.

The Fed’s only in this mess because it ruined its own policy tool of adjusting the overnight lending rate by flooding the market with dollars.

Now, it intends to introduce a policy where the central bank itself is the counterparty to thousands of transactions totaling hundreds of billions if not trillions of dollars.

This move will only increase the Fed’s footprint in the financial markets, instead of letting the central bank step away. While the approach might work as intended, the possibility of unintended consequences grows along with the Fed’s exercise of control.

The Fed is a loose cannon with a lit fuse rolling around on the deck. We all know it’s going to go off, we’re just not sure who’s going to get shot.