December 17, 2015
The Federal Reserve just enacted several changes to monetary policy, raising the benchmark Federal Funds target rate for the first time since 2006. Here are the key takeaways:
1. The target for the overnight interest rate has been raised, and the Fed will aim for 0.25% to 0.50% in the Federal Funds market, which is only traded by banks and the Federal GSEs. Some analysts predicted the Fed would simply target 0.50% and not a range. Accordingly, this move by the Fed gives it flexibility to enact its monetary policy goals where interest rates are still close to the critical zero-bound.
2. The Fed will maintain the size of its $4.4 trillion balance sheet, which is largely composed of Treasury and mortgage-backed securities that are guaranteed by the U.S. government. When the bonds mature, they will be rolled over, meaning the Fed will buy new bonds to replace them. This move was expected, but had the Fed decided to let the bonds “roll off” its balance sheet when they matured, this would have spooked bond markets and spiked rates further.
3. Interest on reserves was raised from 0.25% to 0.50%. This determines the amount of interest the Fed pays banks to keep their money sterilized (out of the economy) and stashed at the Fed. The move was largely expected and helps establish a floor on short-term interest rates. Therefore, banks are encouraged to keep as much money at the Fed as possible to earn a risk-free 0.50% interest rate.
4. The lower bound of 0.25% for the benchmark rate will be effected by the Fed selling its securities to a select group of primary dealers and buying them back the next day. The Fed will use $2 trillion of its bonds in these operations and will limit participation to $30 billion per dealer. The operation is called a reverse repo (or repurchase) and has an overnight maturity, meaning the Fed will be monitoring and conducting these operations every day to maintain the target interest rate range. By selling low and buying high, the Fed puts pressure on rates to achieve its target range.
5. The Fed will conduct longer term operations to drain money as well, using a so-called “term deposit facility” it set up in 2010. At the time, it believed a rate hike was imminent. As we now know, it took an additional five years to get to this point.