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Fed to make another technical fix amid long-term questions on balance sheet


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Fed to make another technical fix amid long-term questions on balance sheet

In another bid to keep its benchmark rate within the target range, the Federal Reserve will likely tweak the interest rate payments it makes to banks when it meets this week.

Still, the U.S. central bank will likely emphasize that the fix is technical in nature and does not signify any broader issues as it continues trimming its $4.1 trillion balance sheet, analysts and economists say.

The central bank is expected to again raise its benchmark interest rate by 25 basis points on Dec. 19, as it has done three times this year. But the interest rate it pays to banks on the excess reserves they hold at the Fed, known as IOER, should only shift up 20 basis points, market observers say.

The Fed has generally increased both rates by the same amount since it began raising interest rates in 2015. But in June, the Fed raised the IOER rate by a smaller amount, saying the technical adjustment was needed due to a higher supply of Treasury bills leading to upward pressure on the Fed's benchmark federal funds rate.

That pressure has continued, putting the Fed in a position to potentially make a second adjustment "fairly soon," according to minutes of the Federal Open Market Committee meeting in November.

Fed officials seem to be "continuing to treat the effective fed funds rate conundrum as a technical issue," Wells Fargo Securities Global Economist Jay Bryson wrote in a research note. But there are broader questions involved with significant implications for the Fed's balance sheet and interest rates, he added.

"With two technical tweaks possible in the span of six months, the stars appear to be aligning for a broader and deeper look at the Fed's monetary policy tools and outlook," Bryson wrote.

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Fed officials want to ensure that the effective federal funds rate — the key rate they target to affect overall interest rates more broadly — remains squarely within the central bank's 25-basis-point range. The effective rate has been drifting upward in recent weeks and currently sits at 2.20%, just 5 basis points away from the top of the Fed's target range of 2% to 2.25%.

Now, market observers expect that the Fed will take action again to prevent its key rate from breaching the top of its target range. Fed officials were preparing for the possibility that they would have to make the technical tweak between their November and December meetings, according to the minutes.

Economists question how much the Fed can trim from its balance sheet

The issue is related to one major long-term question facing the Fed: How much further will it cut its balance sheet?

Last year, the Fed began gradually shedding assets from its portfolio of Treasurys and mortgage-backed securities, deeming the economy healthy enough to begin reversing its postcrisis quantitative easing program. The Fed had paid for those securities essentially by increasing the amount of reserves that banks held at the central bank. Those have now begun dropping as the Fed dials back that process.

At some point, some market observers say, banks should begin seeing shortages of reserves and start borrowing more in the federal funds market — putting upward pressure on the Fed's benchmark rate and again raising the risk that the Fed's key rate will drift above target.

Fed officials do not seem to think that is happening yet. They saw "no clear signs that the ongoing decline in reserve balances in the banking system ... had contributed meaningfully to the upward pressure on money market rates," according to the November FOMC minutes. But the minutes also flagged two New York Fed surveys of primary dealers and market participants who indicated that they foresee overall reserve levels playing a larger role after the first quarter of 2019.

Some economists are skeptical that the Fed will proceed with its balance sheet reductions beyond 2019. That includes Morgan Stanley strategist Sam Elprince, who anticipates that the central bank will be done by September 2019.

"The risk to our view remains that the Fed is willing to wait [longer] before acknowledging the existence of reserve scarcity," Elprince wrote. "This could lead to a later start to the process of ending balance sheet normalization."

Others, including Wells Fargo's Bryson, see the Fed potentially shrinking its balance sheet until late 2019 or perhaps into early 2020.

In any case, market observers say, the Fed's balance sheet will likely end up much larger than the $850 billion pre-crisis level — and with far more reserves in the system than before.

That could lead to political complications for the Fed, as lawmakers sharpen their questioning of the central bank's role in the economy. Some Fed officials said in November that returning to a system with few excess reserves "could demonstrate the Federal Reserve's ability to fully unwind the policies" it implemented during the crisis, therefore making it more politically palatable for the Fed to take such steps in the future, according to the minutes.

But Fed officials also discussed the benefits of a system with abundant excess reserves, including the operational ease of such a system and the financial stability benefits of banks having healthier reserve levels, the minutes show.

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