April's FOMC minutes: Key tools to normalize monetary policy (Part 2 of 7)
Key policy tools
At the meeting held on April 29–30 in Washington, DC, members of the Federal Open Market Committee (or FOMC) and the Board of Governors of the Federal Reserve System met to discuss issues associated with the eventual normalization of monetary policy.
The committee discussed several tools that the Fed could use to raise the Fed funds rate when it chooses. Along with approaches to raising short-term rates, the FOMC also discussed tools that could control the level of short-term rates once rates begin to rise. Monetary policy tools such as the rate of interest paid on excess reserve balances, fixed-rate overnight reverse repurchase (or ON RRP) operations, term reverse repurchase agreements, and the Term Deposit Facility (TDF) were part of the discussion.
Interest on excess reserves (or IOER)
Excess reserves are bank reserves in excess of a reserve requirement set by a central bank. Banks in the U.S. Federal Reserve System park their excess cash reserves with the Fed by making short-term (usually overnight) loans on the Federal funds market. The Fed pays a rate of interest on these excess reserves. So the Fed can directly regulate this short-term interest rate. For example, to encourage more bank lending, the Fed simply needs to reduce this IOER rate, making the “park your excess funds with the Fed and earn an IOER” choice less attractive to banks. As the option becomes less attractive, banks prefer to lend instead of parking funds with the Fed.
A reverse repurchase agreement, also called an overnight reverse repo (or ON RRP) is an open market operation under which the Fed sells a security to an eligible counterparty with an agreement to repurchase that same security at a specified price at a specific time in the future. The difference between the sale price and the repurchase price, together with the length of time between the sale and purchase, implies the interest rate the Fed pays on the cash invested by the RRP counterparty. By changing the repurchase price accordingly, the Fed can indirectly regulate the implied short-term interest it pays on the RRP agreement.
Term deposits will facilitate the implementation of monetary policy by providing a new tool through which the Federal Reserve can manage the aggregate quantity of reserve balances held by depository institutions. Funds placed in term deposits are removed from the accounts of participating institutions for the life of the term deposit, helping drain excess reserve balances from the banking system. However, participants suggested further testing of tools such as the TDF to better assess their operational readiness and effectiveness before implementing.
Rate fluctuations expose investors in Treasury securities to interest rate risk. You can hedge these risks by investing in inverse Treasury ETFs like the ProShares Short 20+ Year Treasury (TBF) and the iPath US Treasury 10-year Bear ETN (DTYS). Besides Treasuries, ETFs like the ProShares Investment Grade-Interest Rate Hedged ETF (IGHG), which has its major holdings in companies like Citigroup Inc. (C) and JP Morgan Chase & Co. (JPM), and the PowerShares Senior Loan Fund (BKLN), also protect against interest rate risk.
The potential implications of each of the above tools for financial intermediation and financial markets, including the Federal funds market, and the possible implications for financial stability, were part of the agenda. The meeting participants also went on to discuss how various combinations of tools could have different implications for the degree of control over short-term interest rates for the Federal Reserve’s balance sheet and remittances to the Treasury.
While the meeting Board of Governors ended with no decision with regard to policy normalization, the FOMC continued its discussion on developments in domestic and foreign financial markets and its economic situation review. Find out more in the next part of this series.
Browse this series on Market Realist:
- Part 1 - April FOMC minutes: A quick recap of 2014′s FOMC meetings so far
- Part 3 - The April FOMC minutes present a must-know view of the economy
- Part 4 - April’s FOMC minutes review key international trade activity
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- Personal Investing Ideas & Strategies
- Federal Reserve System
- monetary policy