As widely anticipated the U.S Federal Reserve (the Fed) raised interest rates last week by 25 basis points on the target Fed funds rate. Investors however, should be aware of a more subtle change that occurred in last week’s announcement that highlights a challenge the Fed are currently grappling with related to control of the effective Fed funds rate (EFFR).
The EFFR is the actual market interest rate that banks charge each other for overnight loans. The Fed sets a target Fed funds band, typically of 25bps, and the EFFR typically trades very close to the middle of the range. As shown in the below chart, the EFFR sat close to the middle of the Fed’s target range for most of this economic cycle. However, over the course of 2018 the EFFR has moved away from the middle of this band likely a result of large debt issuance and a shrinking balance sheet.
The EFFR not trading close to the middle of its band poses a credibility challenge to the Fed and needs to be addressed. In order to deal with the issue the Fed has turned to a tool called the “interest on excess reserves” (IOER). The IOER is the interest rate paid to banks for the deposits they hold with the Federal Reserve above those required by banking regulation.
From December 2008 to June 2018, the IOER has been set at the same level as the top of the Fed funds band. If the Fed increased its Fed funds rate target by 25bps, the IOER rate would increase by the same amount. However, the Fed departed from this convention at its June meeting, increasing the target Fed funds rate by 25bps but only increasing the IOER rate by 20bps. This divergence has expanded further in December 2018 as the Fed have again increased the Fed target rate by 25bps but only raised the IOER by 20bps.
With the Fed moving towards a dual-rate methodology to control financial conditions, investors are witnessing an adoption of a more complicated monetary policy framework. This should not come as a surprise, and investors would be wise to remember that central bankers are in unchartered waters: never before have we seen central banks attempt to unwind such aggressive monetary policy easing.
Interest rates relative to Fed target range
Source: FactSet, Federal Reserve Board, J.P. Morgan Asset Management. Data are as of December 20, 2018.