“If we were to move [to raise interest rates]—say, in December…”

Janet Yellen
U.S. Federal Reserve Chairwoman
November 4, 2015

Many view the larger-than-expected jump in U.S. payrolls (reported by the Labor Department on November 6) as a sign that the U.S. economy is on sufficiently solid footing to allow the Federal Reserve to begin raising interest rates.

The market is currently pricing overnight index swaps for a two-in-three chance of a rate hike in December. Assuming current economic data remains stable, it looks like the Fed’s policymaking body (the Federal Open Market Committee, or FOMC) may have the willpower to finally hike rates. Yet views on the prospect of tighter monetary policy are divided into two camps—both with compelling arguments.

Those in favor of a hike point out that the Fed has been saying for well over a year that it expects to hike rates in 2015. As recently as September, 13 of the 17 FOMC members thought the Fed would raise rates this year, and the now-infamous “dot plot”1 still suggests that most members still expect that to happen. Economic growth has been stable, unemployment (and even underemployment) have fallen to levels that have historically justified rates hikes.

However, as those opposed to a hike emphasize, inflation remains stubbornly low—even according to the “core PCE deflator,”2 the Fed’s preferred measure of inflation. Additionally, economic growth abroad is weak, with a marked slowdown in many emerging markets; and wider credit spreads are already tightening financial conditions in fact—another reason for the Fed to remain on hold (Exhibit 1).

federal reserve, U.S. monetary policy, U.S. interest rates

What Does the Fed Control?

In discussions surrounding a Fed hike, many people doubt that the Fed can hike rates with a balance sheet more than four times larger than it was before the global financial crisis. Our view has been that they can and will be able to do so nonetheless. Such a hike wouldn’t look quite as “pretty” or “elegant” as others before the crisis—but that is mainly an issue of perception rather than reality.

Many market participants understand federal funds rates, repurchase agreements and other short-term instruments better than they did before the crisis. So, if the Fed raises rates and the federal funds rate does not behave exactly as the market perceives it should, there will be calls that the “Fed has lost control of interest rates.” However, we think such calls would be incorrect.

Without getting into too much detail on the Fed’s facilities and interest rate moving mechanisms, it’s important to review what interest rates the Fed can and cannot control (Exhibit 2).

Exhibit 2: What the Federal Reserve can and cannot control

What the Fed directly controls: What the Fed does not directly control:
Interest paid on bank reserve balances Federal funds rate
Overnight reverse repurchase facility rate Treasury yields
Discount rate Repurchase/reverse repurchase agreement rates)
Maximum term deposit facility rate Consumer loan rates (such as for auto loans)

Most important, the Fed does not directly control—and never has controlled—the federal funds rate, which is set by transactions between banks. However, for decades, the Fed has set its own target for the federal funds rate—and then intervened in the markets in an effort to move that rate toward its target over two-week maintenance periods. Traditionally, the Fed accomplished this objective through regular and reverse repurchase agreements with primary dealers, but has rarely been able to keep the federal funds rate exactly on target—even before it deployed quantitative easing (QE)3 in the aftermath of the 2008-2009 financial crisis. As Exhibit 3 shows, there could be many basis points of variation between the Fed’s stated target rate4 and the actual weighted average (or effective) rate.

federal reserve, U.S. monetary policy, U.S. interest rates

Today, the Fed’s reserve balances are too large for it to conduct regular and reverse repurchase agreements with primary dealers, so it developed new programs that would allow the Fed to convert its reserve balances into other liabilities. The most common of these liabilities are likely to be reverse repurchase agreements (RRPs), by which the Fed gives investors (such as money market mutual funds, banks, dealers and federal agencies like the Federal Home Loan Banks), Treasury bonds or mortgage-backed securities in exchange for cash. So long as the Fed pays investors higher rates than what they would receive in the market, presumably all short-term interest rates should move to approximate what the Fed is paying.

The Fed has been testing its facilities for performing these transactions (e.g., its RRP facilities) and they seem to work—except around quarter-end, when banks reduce the assets on their balance sheets for regulatory reasons. In these times, the Fed creates another facility to help with moving the federal funds rate that, though imperfect, seems to help.

Now that we’ve covered how the Federal Reserve seeks to set interest rates, here are the reasons why we think the fear about the Fed being unable to control rates is overblown:

  1. We believe the Fed’s current tools (such as the interest rates on excess reserves, or IOER, as well as the overnight RRP facility) will be effective in raising short-term interest rates. In fact, they already have been.
  2. The size of the Fed’s balance sheet is irrelevant to the level of short-term interest rates, in our view. In fact, no one really knows how big the Fed’s balance sheet should be. In our opinion, the Fed’s balance sheet has to be large enough to meet the economy’s money demands.
  3. Even if the Fed can’t control short-term interest rates perfectly, it’s the Fed’s message about rates that matters to markets and the economy.

The Fed’s facilities have been working. There have been times in the recent past when interest rates have become significantly negative—particularly around periods where the Treasury reduced the amount of Treasury bills outstanding or at quarter-end, when firms reduced the amount of assets they held and were willing to lend their reserves at exceptionally low levels. Although the weighted average overnight interbank lending rate, or federal funds rate, trended much lower during these periods, they never fell below the Fed’s overnight RRP facility rate—and rarely did the market need more than $300 billion to keep the rate within the target range of the federal funds rate.

federal reserve, U.S. monetary policy, U.S. interest rates
Left axis: The amount outstanding in the Fed’s facilities (in $USD billions)
Right axis: Federal funds rate (%)

Source: Credit Suisse, as of November 2, 2015.

To us this suggests that even without a significant increase in these facilities, the Fed should be able to keep the federal funds rate within whatever new range it sets. Presumably, after the first rate hike, the increase will be 25-50 basis points. Raising the overnight RRP facility to 0.3% (30 basis points) should do the job, even without changing any other terms. And if the facility doesn’t work as we suspect, there are other methods the Fed could pursue that we believe will work, such as changing the cap or the time of the operations, or using both term5 and overnight RRPs. So, even if on Day One the federal funds rate doesn’t go in the Fed’s desired direction, the Fed will eventually get it right.

Although we just spent a thousand words describing why the Fed’s ability to control rates remains intact, we maintain that long-term investors should really not have any fear. The bigger question is: What are the likely economic outcomes of a Fed hike—and how might they affect portfolios? Over the coming weeks, we’ll discuss this issue in the context of a portfolio. For now, suffice it to say that for fixed income investors, it’s not as scary as you might think. In fact, we believe a hawkish Fed creates more opportunities.

1 The “dot plot” refers to what FOMC members believe the overnight interest rate should be, assuming their economic forecasts are realized.

2 The Personal Consumption Expenditure (PCE) Deflator is the U.S. Federal Reserve’s preferred measure of inflation.

3 QE is an economic policy enacted by the central bank of a country or region to stimulate a weak economy. The central bank does this typically by purchasing large amounts of government and agency bonds from commercial banks.

4 Before 1993, the U.S. Federal Reserve’s stated target rate was known as the implied target rate.

5 Reverse repurchase agreements of more than one day are typically 7, 14, 28 or 56 days.