This article was written by Invesco PowerShares Senior Fixed & Equity Income Product Strategist Joseph Becker.
The Federal Open Market Committee statement coming out of the Federal Reserve’s (Fed) Dec. 17, 2014, meeting seemed to confirm the market’s consensus view that the Fed will indeed raise short-term interest rates in 2015. Following the statement’s release, the implied Fed funds rate (as measured by the Fed funds futures market) for September 2015 moved five basis points higher than its level on Dec. 16.
Yet while markets may feel more certain about the timing of rate hikes, there remains a degree of uncertainty surrounding the efficacy of the mechanism for rate hikes. The Fed’s unprecedented use of unconventional monetary policy coming out of the financial crisis means that the process of normalizing its policy will also be unprecedented.
Fractional reserve banking system drives price levels
Banks, of course, are in the business of paying low interest rates on deposits and lending them out at higher interest rates. Banking regulations, however, require that banks keep a fraction of those deposits on hand as reserves. It’s through this “fractional reserve” system of banking that money is multiplied throughout the economy. In turn, this money multiplication, or contraction, is a key driver of overall price levels (i.e., the purchasing power of a dollar).
Historically, the Fed’s primary tool of monetary policy has been targeting the fed funds rate, which is the rate at which banks lend to each other overnight. Why do banks need to borrow overnight? To meet their daily reserve requirements.
The Fed has used the fed funds rate as a tool to promote its dual mandate of stable prices and maximum employment — lowering or raising the rate to encourage or discourage overnight borrowing, depending on economic and financial conditions. All else equal, the lower or higher the cost of overnight borrowing, the more or less willing a bank should be to lend out its deposits.
Fed funds rate becomes less effective tool
During the decades prior to the financial crisis, Fed data show that banks generally held minimal reserves in excess of the required level. This meant that banks were generally lending as much as regulatory limits would permit. In recent years, however, the Fed’s unconventional monetary policy of quantitative easing (QE) has created more than $2 trillion of excess reserves in the banking system, as the chart below shows.
The presence of excess reserves means banks don’t need to borrow overnight to meet their reserve requirements, which means the fed funds rate can’t be effective as a tool to encourage or discourage borrowing in my view.
Fed trades stick for carrot
As part of its response to this situation, the Fed released its Policy Normalization Principles and Plans after its September 2014 meeting. In addition to offering principles for normalizing its balance sheet, the Fed also explained how it intends to raise short-term rates in a way that incentivizes banks. Rather than simply raising the fed funds rate via open market purchases, the Fed indicated that it will instead move the fed funds rate “primarily by adjusting the interest rate it pays on excess reserve balances.”
Under normal circumstances, a higher fed funds rate is a punitive, tax-like measure meant to increase banks’ cost of reserves via the minimum reserve requirement. By instead raising the rate it pays on excess reserves, the Fed will be encouraging banks to let those reserves sit safely at the Fed rather than taking on the risk of lending them out.
So where the Fed has historically used a stick, it now intends to use a carrot. Rather than increasing the cost of acquiring reserves, the Fed will be increasing the cost of forgone opportunity. In both cases, the goal is to discourage lending by making the risk less profitable. The primary difference this time around is the $2.5 trillion in excess reserves sitting between the banks’ ability to lend and their reserve requirement threshold.
With QE tapered out and rate hikes seemingly in the forecast, act one of this unprecedented Fed policy experiment appears to have reached intermission. Investors will no doubt keep a close eye on whether or not the carrot can be as effective as the stick when the curtain opens on part two.
In the absence of a clear roadmap to help investors navigate the implications of Fed policy on fixed-income markets, the investor’s toolbox takes on greater importance. The liquidity1, flexibility and transparency2 of fixed-income exchange-traded funds (ETFs) may help investors be responsive to changing conditions as they develop.
1 Since ordinary brokerage commissions apply for each buy and sell transaction, frequent trading activity may increase the cost of ETFs.
2 ETFs disclose their full holdings daily.
There are risks involved with investing in ETFs, including possible loss of money. Index-based ETFs are not actively managed. Actively managed ETFs do not necessarily seek to replicate the performance of a specified index. Both index-based and actively managed ETFs are subject to risks similar to stocks, including those related to short selling and margin maintenance. Ordinary brokerage commissions apply.