Must-Read Pre-Liftoff Lollapalooza: Robin Wigglesworth: How the US Federal Reserve Intends to Raise Rates

Must-Read Pre-Liftoff Lollapalooza: Yes, the Federal Reserve has the tools it needs in order to liftoff interest rates. But how will it use its tools? How it is going to manipulate interest on reserves, the monetary base, reserve requirements, and the amount of duration risk it has taken off the private market will be very interesting to watch…

Robin Wigglesworth: How the US Federal Reserve Intends to Raise Rates: “Buckle up. On Wednesday, the Federal Reserve is expected to raise interest rates for the first time since 2006…

…and reversing the past seven years of extraordinary monetary policy looms as being an experimental, possibly bumpy lift-off. When economists talk about the Fed’s official borrowing rate, they refer to the Fed funds rate, which since late 2008 has been confined to a corridor between zero and 0.25 per cent…. The Fed funds rate sets a benchmark for the cost of credit that ripples through markets and guides borrowing costs for everyone in the US (and much further afield)….

Acting as a floor for now at 0.05 per cent, the overnight reverse repo programme, or Overnight RRP, is primarily aimed at money market funds, and is expected to do much of the heavy lifting. In a typical RRP the Fed’s market desk sells a Treasury bond from its portfolio to a money-market fund and agrees to buy it back the next day at a certain price, a process known as ‘repo’, short for repurchase. In practice, the central bank’s balance sheet does not shrink, but this sets a benchmark for cash interest rates paid by the Fed itself. These RRP operations will happen every business day between 12.45pm and 1.15pm in New York…. Currently the RRP programme is capped at $300bn to avoid the Fed’s operations distorting money markets, but economists expect its size to have to be expanded… to be enlarged to $750bn to $1tn, or perhaps be unlimited in size to ensure a smooth lift-off….

Some economists argue that the Fed should look for a new mechanism to set US interest rates, since the Fed funds market is so small and thinly traded nowadays. There used to be close to $350bn a day that changed hands before the crisis, but daily volumes are now roughly $50bn a day. Some are therefore urging a radical rethink. Even Simon Potter, head of the New York Fed’s markets division — and thus the man that will have to implement the central bank’s decision — hinted that this may be needed…. Fed officials are confident they have the tools to raise the Fed funds rate to roughly where they want it, and while the recent rash of market abnormalities has raised eyebrows, most expect other important interest rates to rise in conjunction. But it could still be a bumpy take-off.