Federal Reserve’s IOER Strategy Set to Fail

There may already be problems coming up with the Fed’s new strategy to manage the policy rate. By raising the IOER rate, the interest paid on excess reserves, by 20 basis points last week, the Fed assumed that it could put some downward pressure on the effective funds rate pushing toward the middle of the policy target range. This idea worked for a few days, but recently started showing trends of a rising effective funds rate.

Analysts say, “Well it was nice while it lasted. For exactly three days the Fed’s strategy worked as intended, with the effective Fed funds rate trading at 1.90%, which is 20 basis points above the level prevailing before last week’s policy announcement. This week, however, the rate is ticking higher again, printing 1.91% on Tuesday and 1.92% on Wednesday. That’s just 3 basis points below the IOER rate of 1.95%.”

Many banks are bidding in the funds market. Yet it’s notable that transaction volumes have fallen sharply. This suggests that a key issue is the supply of funds available to the market. The Federal Home Loan Banks (FHLB) are the primary lenders in the funds market, but they themselves are subject to the behavior of their regional bank clients. If the FHLB has less spare liquidity, they have less money to lend in the funds market. According to recent studies, 90% of reserves are held by just 5% of the banks. There are two important implications of this skewed distribution. The first is that many and most banks will lose their excess reserve holdings before the system as a whole does. This will also put further upward pressure on the funds rate. The second is that banks that do have reserves will tend to be large, systematically important ones.

On a different perspective, an effective funds rate rising more than the Fed would likely suggest a shortage of dollars out there. However, a flat-lining Libor begs to differ. Looking at the recent years, cross-currency basis swaps have been the go-to indicator to identify a global dollar shortage. Yet despite the tax-reform-induced withdrawal of dollar liquidity from global markets, the basis, an indication of implied rate premium that the dollar commands in the FX swap market has collapsed to its tightest levels in the years. With everything kept in mind, there could be a potential that banks run out of excess reserves soon and that the upwards pressure on the funds rate might not be going away.

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