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12 17 2015 | by Victor Xing | Central Banks

What is FED’s mechanism to control interest rates?

The Federal Reserve can utilize an array of conventional and unconventional policy tools to control interest rates.  Ironically, it was the unconventional policy easing (QE) in the preceding years that had given the central bank one of its most powerful tools to raise rates – the Overnight Reverse Repurchase Agreement, the ON RRP program.
How ON RRP works (or will work in the next few hours – please also see: December FOMC (Dec 16th): “End of an extraordinary 7-year period”):
  1. The Federal Reserve has dedicated $2 trillion of its assets – almost half of its balance sheet, as collateral to borrow (drain) cash from the market
  2. The NY Fed trading desk will go to the market and borrow cash from money market funds, GSEs, and depository institutions (cap for each of these institutions will be at $30 billion).  In exchange, the institutions will receive securities from the FED’s balance sheet as a collateral.  The NY Fed trading desk would pledge to buy back the asset with interest on the next day.  This interest rate would become the effective “floor” of FED’s target funds rate range
  3. With the FED being the biggest borrower at the market place, anyone trying to borrow at a rate lower than the rate offered by the FED will find no takers, and they will need to match the FED’s offer in order to attract lenders
Today the Federal Reserve raised the Interest on Excess Balances (or interest on excess reserves, the IOER) rate from 0.25% to 0.50%, and with the FED scheduled to become the most generous borrower at open markets tomorrow, the funds rate’s lower bound will begin to converge toward the ON RRP rate.
IOER and ON RRP are FED's policy tools to control interest rates
IOER as the upper bound of the funds rate target range; ON RRP would establish the floor
The FED can also elect to sell assets from its balance sheet to control interest rates, which would directly push up yield through three channels:
  1. The flow channel: outright asset sales will push up yields
  2. The expectation channel: market participants concerned about further selling will sell more assets to de-risk
  3. The stock channel: FED’s balance sheet Agency MBS Reinvestment Purchases and Treasury Rollovers program allows the FED to reinvest principal repayments in new bonds, thus acting as “mini QE.”  If the FED had already reduced its balance sheet, then the potential for future reinvestment purchases would also be reduced
Finally, the FED can also begin to “taper” its reinvestment program, and this would directly reduce the size of (almost daily) bond purchases, thus providing less support for yields in the 5 to 10 year sector.
Original Quora article

Next article12 17 2015 | by Victor Xing | Economics

Is Larry Summers right that the rate hike is premature?