New Fed Exit Strategy Emerges and Foreign Banks Big Winners

From Real Time Economics:

Federal Reserve officials haven’t decided when to raise short-term interest rates, but as The Wall Street Journal reported earlier this week, they are closer to finishing a blueprint for how they’ll do it.

Minutes of the Fed’s July 29-30 policy meeting laid out fresh details and elaborated on others. Among the big winners in the new approach–as we’ll explain lower in this post–are foreign banks.
But first the details:

• Rather than target a specific federal-funds rate, as it did before 2008, the Fed in the future will try to keep its target interest rate within a band. Right now it is between 0% and 0.25% and when it decides to raise rates the Fed will move that quarter-percentage point band higher. “Almost all participants agreed that it would be appropriate to retain the federal funds rate as the key policy rate, and they supported continuing to target a range of 25 basis points for this rate at the time of liftoff and for some time thereafter,” the minutes said.

• The Fed’s primary tool is an interest rate it pays banks for the money they have on deposit with the central bank, known as interest on excess reserves, or IOER. This will be the upper end of the band. This rate is now 0.25% and seems likely to go to 0.5% with the Fed’s first rate increase. The lower end of the band will be interest the Fed pays money market funds and other nonbanks for cash not on deposit at banks (known as the overnight reverse-repo rate, or ON RRP in Fed lingo). This is now 0.05% and seems likely to go to 0.25% with the Fed’s first rate increase. “Most participants anticipated that, at least initially, the IOER rate would be set at the top of the target range for the federal funds rate, and the ON RRP rate would be set at the bottom of the federal funds target range,” the minutes said.

• The Fed wants to gradually shrink its securities holdings and eventually get its portfolio of mortgage-backed securities to a minimum.

• After the Fed starts raising short-term interest rates using these tools, officials will allow their holdings of all securities to shrink as the securities mature. Right now, the Fed is reinvesting proceeds from maturing securities to keep the size of its portfolio stable. “Most participants supported reducing or ending reinvestment sometime after the first increase in the target range for the federal funds rate,” the minutes said.

• The Fed is going to avoid disrupting financial markets by selling its securities, unless absolutely necessary or for fine-tuning its portfolio. “Most participants continued to anticipate that the Committee would not sell (mortgage-backed securities), except perhaps to eliminate residual holdings.

• Fed officials are on track to formalize the plan in September, but want to give themselves wiggle room because they’ve had to revise their vision of this process before and they’re still learning how to use some of these new levers. “Participants agreed that the [Fed] should provide additional information to the public regarding the details of normalization well before most participants anticipate the first steps in reducing policy accommodation to become appropriate. They stressed the importance of communicating a clear plan while at the same time noting the importance of maintaining flexibility so that adjustments to the normalization approach could be made as the situation changed and in light of experience.”

The most striking feature of the Fed’s strategy is that it keeps in place an effective subsidy that the U.S. central bank is currently paying to foreign banks.

Here’s how:

In recent years foreign banks have been tapping U.S. money market funds for very cheap short-term loans. Unlike domestic banks, foreign banks don’t have domestic depositors to tap for funds, so they turn elsewhere for dollars. Money market funds make the funds available for a few hundredths of a percentage point. The foreign banks in turn park those loans at the Fed for 0.25% interest. They earn profits on the spread between the cheap cost of funds available from money market funds and the higher rate they get at the Fed....MORE