August 2018

The Federal Reserve’s (the Fed’s) interest on excess reserves (IOER) shot to prominence last month following an unprecedented adjustment by the central bank. What was the rationale for the change and what, if any, are the implications for markets and investors?

The evolution of Fed monetary policy

Depositary institutions hold required and excess reserves on deposit at the Fed. They are allowed to borrow and lend their excess reserves to ensure they meet their required reserve obligations. The effective fed funds rate (EFFR) is the volume-weighted, daily traded rate of all this activity (Exhibit 1a). It is actually a market driven rate, but influenced by the Fed to ensure it remains close to the fed funds target rate (FFTR).

Historically, the Fed influenced interest rates via its open market operations. However, during the global financial crisis, the Fed’s quantitative easing programme injected a massive amount of liquidity into the banking system, effectively removing the structural short in fed funds and boosting excess reserves (Exhibit 1b). The need for banks to trade fed funds declined sharply and the effectiveness of the Fed’s open market operations was significantly reduced.

The increase in excess reserves was an unintended consequence of quantitative easing.

Source: Federal Reserve, Bloomberg and J.P. Morgan Asset management; data as of 7 July 2018.

In response to substantially lower fed funds trading activity, the Fed introduced two new monetary policy tools: interest on excess reserves (IOER), which acts as a ceiling; and the overnight reverse repo programme (ON-RRP), which acts as a floor. Since the Fed began raising rates in December 2015, it has increased its target rate, IOER and ON-RRP in tandem and by the same amounts.

The Fed’s interest rate challenge:

Recently, the Fed’s monetary policy model has shown signs of stress as the EFFR moved towards the top of the Fed’s target trading range and the EFFR/IOER spread narrowed to a post-global financial crisis low (Exhibit 2a). In his latest testimony, Fed chairman Jerome Powell expressed uncertainty about the reasons for the EFFR movement, exacerbating market concerns about rising funding costs, tighter liquidity conditions (Exhibit 2b) and the impact of the Fed’s balance sheet reduction.

The spread between IOER and the effective fund rate has narrowed to a seven- year low.

Source: Federal Reserve, Bloomberg and J.P. Morgan Asset management; data as of 7 July 2018.

Nevertheless, to ensure that EFFR continues to trade within its target range, the Fed raised the IOER by only 20 basis points (bps) while raising other rates by the customary 25bps at the Federal Open Market Committee meeting in June. This unusual adjustment provides a strong signal of the Fed’s intention to prevent the EFFR breaching the IOER ceiling.

Much ado about nothing?

In reality, the EFFR breaching the IOER or the Fed target range should have no major operational implications; however, many market participants would view such an event negatively and question the Fed’s ability to control a historically important benchmark rate.

For now, it appears that the Fed’s IOER adjustment has achieved its goal, although the continued challenges of increased Treasury bill issuance and the Fed’s balance sheet reduction suggests the problem may re-emerge. Any further deviations will trigger additional Fed actions – which could range from another adjustment of the IOER to something potentially more drastic, such as an early end to the Fed’s balance sheet reduction programme.

For US dollar cash investors, a hawkish Fed and tighter funding are significant positives, pushing interest rates higher and boosting returns on cash investments. As real rates approach their highest level in almost a decade and commercial paper offers a significant yield pickup over Treasuries, cash investments have re-emerged as an important asset allocation choice.

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