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No, the Fed Did Not Just Hike Interest Rates

Christopher M. Russo
Discourse Magazine
Published July 6, 2021 (812 words)

In June, the Federal Open Market Committee left in place the Federal Reserve’s existing target range for overnight interest rates at 0% to 0.25%. Yet the committee did increase the rate it pays on overnight reverse repurchase agreements, and the Board of Governors increased the interest on reserve balances rate. Has the Fed hiked interest rates by stealth? As Louisiana Sen. John Kennedy recently asked Treasury Secretary Janet Yellen, is the Fed secretly worried about inflation?

The short answer is no. Rather, the recent technical adjustments by the Federal Open Market Committee (FOMC) maintain the Fed’s intended monetary accommodation. The following Q&A addresses some of the common concerns and misconceptions about the FOMC’s recent actions.

What are overnight reverse repurchase (ONRRP) agreements and reserve balances? How are they related to “administered rates”?

ONRRP agreements and reserve balances are two categories of Fed liabilities. ONRRP agreements are used by government-sponsored enterprises and money market funds to invest their cash overnight. Reserve balances are cash deposits that eligible banks hold at the Fed. The Fed chooses to pay interest on both these liabilities. Because these interest rates are determined by policymakers and not the market, they are called administered rates.

Why does the Fed pay interest on ONRRP agreements and reserve balances?

The Fed pays interest on these liabilities to keep rates within its target range. Because the Fed’s balance sheet is so large, the financial system is flooded with dollars, and overnight rates are pushed downward. By paying interest on these liabilities, the Fed puts a floor on how low overnight rates can fall.

Think of administered rates as the opportunity cost for financial institutions to make an overnight loan in the money market. They won’t lend at a rate less than they could get from the Fed. So except in extreme circumstances, comparable market rates stick closely to the Fed’s administered rates.

Why does the Fed change its administered rates?

The Fed changes its administered rates to keep overnight rates within its target range. Suppose the Fed raised its target range to 0.25% to 0.5%, a quarter-percent increase. To raise overnight rates to be within its new target, the Fed would also increase its administered rates by a quarter percent. The Fed sometimes makes small tweaks to administered rates without changing its target range. These “technical adjustments” help keep the rates toward the middle of the Fed’s target range.

Aren’t these “technical adjustments” just rate hikes by stealth?

No. Far from being a tightening of monetary policy, June’s technical adjustments help maintain the Fed’s intended accommodation by keeping rates within its target range.

In recent months, rates have drifted to the bottom of the Fed’s target range. These technical adjustments help prevent rates from drifting negative. Policymakers raised the ONRRP rate from 0% to 0.05% and the interest on reserve balances (IORB) rate from 0.1% to 0.15%. These changes successfully raised comparable market rates. The secured overnight financing rate increased from 0.01% to 0.05%, and the overnight bank funding rate increased from 0.04% to 0.08%.

By analogy, all good drivers know to keep their car in the center of the lane. A slight drift right bears no consequence, yet continued drift leads into a ditch. We readjust, turning the wheel slightly left. Recentering in the lane is not the same as changing lanes or turning off the highway. It’s just commonsense driving.

Even so, leaving aside the Fed’s intentions, won’t rate increases tighten money and credit?

No, these tiny increases are not economically meaningful. Consider a stylized example. A bank originates mortgages and keeps them on its balance sheet. These mortgages pay 3% interest, the prevailing rate for 30-year mortgages according to the Freddie Mac Primary Mortgage Market Survey. Suppose these mortgages are financed entirely by deposits earning the overnight rate. Therefore, the bank earns the difference between the mortgage rate and the overnight rate. The bank won’t be deterred from lending at 3% because overnight rates rose from 0.01% to 0.05%. Such a small change amounts to rounding error.

Or consider it from your own individual perspective. Suppose your checking account at the bank has $10,000. If your interest rate rises by 0.04%, then your annual interest income rises by a meager $4. Enjoy your extra latte.

The Board of Governors, not the FOMC, sets the IORB rate. Since overnight rates track IORB, doesn’t that make the FOMC just a rubber stamp for the Board of Governors?

No, as clarified by former Fed Chairman Ben Bernanke. The FOMC includes the presidents of the Federal Reserve Banks and the governors of the Board of Governors. It decides policy. However, due to quirks in the Fed’s legal structure, the Board of Governors alone has certain technical authorities like setting the IORB rate. Long-standing institutional norms require that the board subordinate those technical authorities to the decisions of the full FOMC. And it does.