The last time the Fed raised the Fed funds target was July 2006. Back then the level of excess reserves – funds banks have on deposit at the Fed that exceed the level of reserves mandated by law, was small. The Fed funds rate is what banks pay when they borrow or lend reserves to one-another. Before QE, the central bank could sell securities to drain funds from the banking system, raising the cost of borrowing needed reserves. After three rounds of QE, excess reserves are close to $3 trillion, far too large for the Fed to nudge rates higher by selling securities.
With the advent of QE, some questioned whether the central bank would be able to control interest rates until QE was reversed and $3 trillion of reserves somehow vanished. Last fall the Fed announced new operating procedures for managing the Fed funds rate. The ceiling on the Fed funds rate is set by the interest rate the Fed pays banks on excess reserves on deposit at the Fed. With the Fed paying one-quarter percent on excess reserves, there is no reason for a bank to lend overnight to anyone else at a lower rate. The floor is set by reverse repurchase agreements (RRP) where the Fed sells securities and agrees to buy them back at a slightly higher price, the difference determining the interest rate. The availability of RRPs encourages non-banks with funds to invest not to seek a return lower than the RRP rate. Paying interest on reserves has been in place for a few years, the RRP process has been tested. The Fed can manage the Fed funds rate.
When
Friday’s Employment Report of 295,000 jobs added in February is merely the latest piece of strong economic news. The unemployment at 5.5%, also reported in Friday’s Employment data, is in the range that the Fed terms as full employment – it would be nice to see it move lower, but the risk of inflation might move up from here. At the same time, wages are still not rising much, if at all, so there is no immediate reason for the Fed to act. Most forecasts look for the Fed to raise interest rates in the second half of 2015, a few suggest as early as June and some as far away as 2016. Among those Fed members who have comments, the same wide range holds.
Friday also gave the markets a taste of things to come: the Employment Report spooked investors and sent major equity indices tumbling. Zero interest rates can’t go on forever; something that can’t go on forever must, sooner or later, come to an end. The Fed will raise interest rates, no one (not even Janet Yellen) knows when. And, until the Fed acts there will be moments like Friday when the fear of rising rates scares markets.
This article was written by David Blitzer, chairman of the index committee, S&P Dow Jones Indices.
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