Fed Experiments with Raising Rates

Preamble: Apologies for inaugurating this blog with a geeky post on short term interest rates.

FOMC to begin experiments in the short end. Concurrent with the announcement of the end of quantitative easing, the FOMC directed the NY Fed to begin adjusting the overnight reverse repo (RRP) rate from its current level of 5 basis points through a range of 3 to 10 basis points. The primary takeaway here is that for a short period of time, from December 1st through December 12th, the Fed will raise its RRP rate to 10 basis points, deliberately exceeding the recent average daily fed funds rate of 9 basis points. There are a few reasons for the Fed to test this prior to raising interest rates:

1. It will potentially allow the Fed to gauge how funds will flow between the unsecured, inter-bank (fed funds) and the secured (general collateral Treasury), money-market dominated repo markets when the Fed begins raising rates.
2. There are technical problems dating back to the financial crisis with using the fed funds rate as a benchmark for monetary policy. The FOMC has already stated that it intends to supplant the fed funds rate, and instead use the interest on excess reserves (IOER) rate (currently 25 bp), augmented by the overnight reverse repo rate, as their primary tools of monetary policy during this cycle.
3. For example, if the FHLBs - who have long been the dominant lender in the inter-bank market - quit lending in the fed funds market in favor of parking money in the Fed's reverse repo program when the rates inverted, the daily average fed funds rate would likely jump from 9 bp to about 30 bp. That's an important flow to test in advance, as over the long term it could meaningfully impact liquidity, and change the Fed's and the market's projections for some short-term rates.  
4. The purpose of the experiment is to help the FOMC determine what the appropriate spread should be between reverse repo and IOER, and how funds will flow through the short-term markets once they begin raising rates.

This has been a popular discussion among Fed-watchers and short-term interest rate experts (yes, Clarice, they do exist) for several months now, and will no doubt garner more headlines if the markets show any signs of volatility as the experiment proceeds.

Why is this a big deal? Short-term financing is like the oxygen of the financial markets - it's completely taken for granted until there isn't enough to go around; at which point panic breaks out and liquidity in entire markets can go "whoosh!" overnight. See: sub-prime mortgages, auction rate securities, Bear Stearns. The high profile hand-wringing over the Fed's exit strategy in the financial press popularly centers around a potential bubble bursting in the equity market. However, fixed income analysts (raise your hands) are just as anxiously watching the short-term funding markets for any symptoms of stress. Despite all the assurances from the FOMC that they have the necessary tools to manage the exit, the short-term financing markets have undergone epic regulatory and structural changes since the crisis. The number of participants, their segregation across markets, the cost of capital and the fungibility of financing vehicles have all changed dramatically, and neither we nor the Fed really know what the response could be during a period of stress. Hopefully these experiments will give the Fed and the market a first glimpse of any baseline liquidity issues that might develop when the FOMC begins to raise interest rates.