The Fed Lifts Off, Slowly
Ending a Zero-Rate Era, Carefully
In the months after the U.S. Federal Reserve first began pulling back on the greatest stimulus in its history, the question had been, when would it act again? On Dec. 14, the Fed’s policy-making committee finally nudged rates higher for a second time, almost exactly a year to the date when it last voted in favor of “liftoff,” the first increase in its interest rate target. Officials at the central bank have envisioned rates slowly creeping upward in a way that puts the economy near full employment with inflation averaging around 2 percent. That creeping turned out to be slower than originally thought. The bank had pushed the federal funds rate target to near zero after the 2008 financial crisis. Before the first increase in December 2015, former Fed Chairman Alan Greenspan predicted: “There is no conceivable scenario in which it is going to be easy.” Then came Donald Trump's election as U.S. president in November.
The Federal Open Market Committee voted to raise the target for the fed funds rate — the overnight lending rate between banks — to a range of 0.5 percent to 0.75 percent. It had set the stage for a second rate move in its Sept. 21 and Nov. 2 decisions, but Trump’s victory raised potential complications. He vowed to rewrite economic policy and tear up existing U.S. trade agreements and had been seen by investors as less predictable than his Democratic opponent, Hillary Clinton. Before the Nov. 8 election, the FOMC had released statements saying the case for another hike had gotten stronger, along with forecasts in September that pointed to one quarter-point increase in 2016 and two hikes in 2017. In December, policy makers' forecasts projected three quarter-point hikes in 2017 and a higher overall trajectory for rates than they had in September. A year earlier, when the FOMC voted to establish a target range for the fed funds rate of 0.25% to 0.5%, the FOMC’s median estimate had implied four quarter-point hikes each in 2016 and 2017.
The Fed sets monetary policy by adjusting the interest rate that big banks pay each other for overnight loans, the fed funds rate. Changes in that rate ripple through the economy, affecting employment, output and the price of goods and services. Just as the Fed had to cook up unconventional tools such as its bond-buying program to stimulate the economy, it’s been using new tools for raising the fed funds rate and thereby ratcheting stimulus down. Its main focus is the huge pile of cash banks have parked at the Fed since the 2008 crash. To get the fed funds rate up, the Fed in December increased the interest it pays on those so-called excess reserves to 0.5 percent. A higher rate gives banks a risk-free alternative to transactions like making loans or buying securities that earn less, thereby forcing the interbank rates up toward the Fed’s preferred level. The Fed is also using another form of overnight borrowing, known as reverse repo, that's available to money-market funds and other large non-bank investors as well. In a reverse repo, the Fed borrows securities overnight at a rate high enough to discourage lending at rates below the target range. The Fed is cushioning the effect of its interest rate hikes by putting off a reduction of its $4.5 trillion balance sheet, which was swollen by bonds purchased through its so-called quantitative easing program.
During the presidential campaign, Trump was scathingly critical of the Fed's low-rate policy and called the central bank “a political arm” of the Obama administration. Speaking of Fed Chair Janet Yellen and rates, he said, “She knows that she’s supposed to be inching them up.” Yellen has said, “We do not take politics into account in our decisions.” The president-elect could significantly alter the composition of the Fed's board in the next year or more, and conceivably appoint as many as five of the central bank's seven governors in Washington. Not only are there already two governor vacancies, but there's scope for up to three more seats to change. Yellen's term as Fed chair and Stanley Fischer's term as vice chair expire in 2018.
The Reference Shelf
- The Federal Reserve’s FAQ on rate normalization, and its page on reverse repo.
- A speech by Fed Chair Janet Yellen in March 2015 on normalization, and a 2014 talk by a New York Fed official on the details of the plan.
- An article on the Seeking Alpha blog on interest on excess reserves.
- A Marketplace.org explainer on reverse repo.
- QuickTakes on the repo market and forward guidance.
- A Bloomberg Benchmarks podcast gives perspective on Fed-speak and FOMC minutes.
- A Bloomberg News retrospective on seven years of zero rates.
First published June 16, 2015
To contact the editor responsible for this QuickTake:
John O'Neil at email@example.com