When the U.S. Federal Reserve raises its key interest rate, it usually bumps up its interest payments to banks by the same amount, but the Fed is expected to stray from that pattern this week.
The U.S. central bank is expected to make a technical change to the interest payments banks get for any excess reserves they store at the Fed. The change would increase those payments by a slightly lower amount than banks are used to.
The action is partly due to rising U.S. government deficits rippling through the money markets, making the Fed's benchmark rate trade at higher-than-expected levels. Analysts, though, say it also reflects some of the longer-term decisions that the Fed will have to weigh as it continues trimming its roughly $4 trillion balance sheet.
The change is aimed at addressing an issue that popped up in recent weeks. The effective federal funds rate, a market-based measure that the Fed influences to achieve its monetary policy strategy, is currently 1.70%. That is at the higher end of the Fed's current target range of 1.5% to 1.75%, potentially raising concerns that the effective rate could creep up and breach the upper limit.
"There would really be no major economic disruption from that, but [the] perception that the Fed has perhaps lost some control over ... that effective fed funds rate, I think, would be concerning to the Fed," Wells Fargo Securities economist Michael Brown said.

The Fed, then, is looking to bring the effective rate closer to the midpoint of its 25-basis-point target range.
Analysts expect that the Fed will raise its key rate again June 13, lifting it by 25 basis points to a new target range of 1.75% to 2%. The Fed would usually also raise the interest on excess reserves, or IOER, payment rate to banks by 25 basis points and have it match the top end of the range.
This time, though, it will likely only raise the IOER rate by 20 basis points and set it at 1.95%, instead of 2%, hoping that the effective federal funds rate will move down by a similar amount.
The Federal Open Market Committee hinted at the change in the minutes of its May meetings.
The Fed largely attributed the recent technical issue to an increase in Treasury bills, the supply of which has been rising partly due to higher U.S. deficits. The increase in Treasury bill supply has helped push up rates on repurchase agreements, or repos, the minutes say. That has "reportedly made repos a more attractive alternative investment" than the federal funds market, leading to the increase in the effective federal funds rate, the minutes say.
The central bank, though, expects that the federal funds rate will also face upward pressure as the Fed continues reducing its balance sheet, which rose to about $4.5 trillion after the financial crisis. The Fed may face a longer-term question on its monetary policy framework as that effort continues, analysts and some Fed officials say.
During the recession, the Fed bought unprecedented amounts of Treasurys and mortgage-backed securities in an effort to boost the economy. But in doing so, the Fed helped flood depository institutions with an excess supply of reserves. That ensured that its traditional way of influencing the federal funds rate — buying and selling Treasurys through open market operations — would be much less effective.
The Fed, with Congress' approval, introduced a system reliant on the IOER payments to banks so that the central bank would still be able to influence the federal funds rate.
Now that the Fed's balance sheet is falling, bank reserves are also seeing a similar decline, Wells Fargo's Brown said, though he added that Fed officials may be somewhat surprised by how quickly that has happened.
It is not clear yet when the Fed plans on ending its balance sheet roll-offs, though Fed Chairman Jerome Powell has said he envisions the Fed potentially ending up with a total between $2.5 trillion and $3 trillion.
As that effort proceeds, the Fed will reach a "crossroads" on whether it wants to go back to its old way of conducting monetary policy or stick to the new one, BofA Merrill Lynch Global Research rates strategist Mark Cabana wrote in a note to clients. The old approach relies on fewer reserves, while the new one needs an "abundance of reserves," he wrote.
A number of Fed officials think they should discuss their options for a monetary policy framework "before too long," the minutes of the FOMC's May meeting show.
But the Fed could face some difficulties as that debate picks up, Cabana wrote. Money markets have tightened partly due to "nascent signs of reserve scarcity," and any further tightening could restrict how much the Fed can unwind its balance sheet, he wrote. Banks may also not want to part ways with their excess reserves, which help boost their standing under liquidity regulations.
"If we are right that banks will be reluctant to see their cash holdings materially decline, then this will limit the extent by which the Fed can ultimately reduce the size of its balance sheet," Cabana wrote.

