Must-know: What other monetary policy tool is available to the Fed?

Market Realist

Why the Fed is testing new monetary policy tools (Part 5 of 5)

(Continued from Part 4)

About the Fed’s term deposit facility

Another way for the Feds to control short-term rates is to offer the bank’s term deposit facility to invest for a longer period than the overnight reverse repo (or RRP) facility.

Dr. Dudley acknowledged the following two issues with the term deposit facility:

  1. To strengthen monetary policy control, it would be necessary to move $2.7 trillion of reserves into the term deposit facility.
  2. The Fed would have to pay higher interest for the term deposit relative to what it intends to pay for the RRP facility.

Dr. Dudley called for considerable testing, analysis, and discussion before reaching any conclusion on the appropriate policy to control money market rates. He added, “My goal would be to clarify our intentions later this year, long before we begin to contemplate raising short-term rates.”

He told the audience that the choices mentioned during the speech apply to monetary policy in the transitional phase—it isn’t about the long-term monetary policy framework. The longer term consideration would be whether to go back to a pre-crisis, corridor-type system (a system where the discount rate is set above the target interest rate and the IOFR rate is below it) or to adopt the floor-type system (a system where a floor is created for the market interest rates) as the Fed’s balance sheet gradually normalizes. Dr. Dudley said that the choices made in the near-term won’t forestall any options over the longer-term.

However, the normalization process can only start if the economy is strong enough to fully utilize the country’s resources—especially the labor resources, which in turn will push the inflation back to the Fed’s long-term objective of 2%. He concluded by saying, “Although we are making progress towards our goals, we still have a considerable way to go.”

As the economy improves and takes inflation higher, the Fed will contemplate raising the interest rates. The move will affect the bond market (BND) to a varying degree. The Treasury bonds (TLT) will be affected the most while investment-grade bonds (LQD) and high-yield bonds (HYG) may be affected to a lesser extent. The improvement in economy will lead to improvement in corporate performance which in turn will boost the stock markets (SPY).

To learn more about Mr. Dudley and why investors should pay attention to his speech, continue by reading the Market Realist series Why investors should pay attention to William Dudley’s speech.

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