The Federal Reserve on Wednesday made a small, but important tweak to its monetary policy framework that offers a valuable clue to where the size of the US central bank’s balance sheet could be heading in the coming years.

The central bank raised its Fed funds target rate range to between 1.75 per cent and 2 per cent. But officials raised an interest rate it uses to control the Fed funds rate by just 20 basis points to 1.95 per cent, rather than the customary 25bp increment.

The change, while technical, might signal that the US central bank will not be able to shrink its balance sheet as much as commonly expected.

The rate that was tweaked, known as the IOER, or “interest on excess reserves”, is the interest the Fed pays on money held at the central bank, and has until now acted as the upper level of its corridor, while the “overnight reverse repo programme”, or RRP, has been the de facto floor for the Fed funds range.

The primary driver for this adjustment is that the Fed funds rate has recently drifted up towards the higher end of the Fed’s target range. Since it began raising rates in late 2015, the key rate has averaged about 10bp below the upper end of the corridor. But this year it has moved to just 5bp below the top of the range — a change that has vexed policymakers.

“They have been perturbed that it has drifted up from the central point of the corridor,” said Larry Hatheway, chief economist at Gam, a Swiss asset manager. “Central banks don’t want to be seen to not be in control.”

In a supplemental statement on Wednesday, the Fed said: “Setting the interest rate paid on required and excess reserve balances 5 basis points below the top of the target range for the Federal funds rate is intended to foster trading in the federal funds market at rates well within the [Fed’s] target range.”

The Fed funds rate has been nudged higher by the central bank, slowly draining “excess reserves” from the financial system, which has started to have a bigger than expected impact on short-term money markets.

The Fed has historically controlled the Fed funds rate by controlling how much money sloshed around in the Fed funds market. If it wanted to lift interest rates, the central bank sucked funds out by selling Treasuries it had in storage to commercial banks, and taking money out of their accounts at the Fed. When it lowered interest rates, it pushed money into the market by buying Treasuries from the banks.

But the Fed’s crisis-fighting quantitative programme entailed buying massive amounts of bonds from banks and crediting their accounts at the Fed with new money — flooding the financial system with surplus Fed funds and forcing the central bank to start using IOER and RRP to control the Fed funds rate.

Since last year, the US central bank has begun to gingerly shrink its balance sheet by gradually reducing how much of maturing bonds it reinvests in the market. As a result, the total assets held by the Fed has slowly dipped from about $4.5tn to $4.32tn as of last Wednesday.

Fed officials have remained silent about just how far it will shrink its balance sheet, but some economists and analysts say that the gradual rise in the Fed funds market could indicate that the “excess reserves” sloshing around the Fed funds market are not as abundant as previously thought. That could in turn mean that the US central bank will not be able to shrink its balance sheet as much as some had expected.

Some analysts were sceptical that the rise in the Fed funds rate had been driven by nascent tightness in the Fed funds market, arguing that other forces were at work.

Krishna Guha of Evercore ISI argued it was more likely driven by rising rates elsewhere — such as in the interbank money market and short-term Treasury yields — caused by a surge of Treasury bill issuance this year and US companies repatriating money held overseas, where much of it was lent to banks. Nonetheless, he too suspects the Fed’s balance sheet trimming would not be as sizeable as many have expected.

Seth Carpenter, chief US economist at UBS, estimates that the balance sheet would probably not go below $3.5tn, a level it will hit in mid-2020. But given that officials have indicated that they want to get the Fed’s holdings of mortgage-backed bonds to zero, that would mean that the Fed will actually have to start buying Treasuries again around then to counteract continued mortgage bond shrinkage.

“It could be even earlier, depending on here they want excess reserves to settle,” Mr Carpenter said.



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