Nov 29 (Reuters) - The U.S. Federal Reserve looks set to make its second adjustment in six months to the systems it uses to control interest rates as it appears on course for yet another rate increase at its meeting next month.
Minutes released on Thursday of the Fed’s latest two-day policy meeting on Nov. 7-8 showed the Fed is also debating whether its ability to ensure its policy rate is effectively transmitted into the banking system is best achieved in an environment where banks’ stockpiles of excess reserves at the central bank are abundant or scarce. Excess reserves are those funds deposited at the Fed that exceed the amounts required under bank safety and soundness regulations.
Fed Chairman Jerome Powell suggested a technical adjustment to the so-called interest on excess reserves rate, or IOER, might be appropriate “fairly soon” to prevent an upward drift in this rate within the overnight lending rate band the central bank sets at each meeting, according to the minutes.
The minutes also reflected that almost all Fed officials at their last meeting agreed another interest rate increase was “likely to be warranted fairly soon,” but also opened debate on when to pause further hikes and how to relay those plans to the public.
To keep the federal funds rate, the Fed’s benchmark interest rate, within the quarter-percentage point range set by policy makers at each meeting, the Fed uses two other interest rates: IOER near the top of the range, which is only available to banks, and the overnight reverse repurchase rate at the bottom, which is available to a wider range of institutions. Currently that fed funds rate is within a range of 2.00 to 2.25 percent after eight rate hikes beginning in December 2015.
The problem facing the Fed is that as reserves have drained from the system through rate hikes and the reduction of its portfolio of bonds, the fed funds effective rate has been drifting toward the high end of the range.
To contain that, the Fed in June only raised the IOER rate by 20 basis points at the same time that it raised the fed funds target range by 25 basis points. That created a 5-basis point buffer between the two designed to keep the fed funds target rate inside the desired range.
Since September’s rate increase, however, the fed funds target rate has been consistently trading exactly at the IOER rate, and some analysts worry that as reserves shrink further it will drive the Fed’s target rate above IOER and possibly above the fed funds range.
“With the funds rate drifting up within the range again in recent months, the committee suggested at this meeting that IOER might rise only 20 basis points in December, to again help move the funds rate toward the middle of the target range,” said Bob Miller, head of U.S. multi-sector fixed income at Blackrock Inc. That would widen the buffer between the top of the fed funds rate and the IOER rate to 10 basis points.
Moreover, the Fed now appears to be leaning toward an environment in which it maintains an abundance of bank reserves to help it attain its policy rate goals, Miller said. That suggests the Fed may opt to maintain a larger permanent holding of bonds.
About a year ago, the Fed began allowing the more than $4 trillion of bonds on its balance sheet to mature without replacing all of them, which reduced its overall bond holdings. This has been one of the primary drivers of the reduction in bank reserves.
“These minutes suggest the committee may prefer abundant reserves and thus a larger balance sheet,” Miller said.
Editing by Dan Burns and Lisa Shumaker