Thursday, 21 August 2014

The topsy-turvy world of the Fed's exit strategy: all too familiar to emerging countries

Jon Hilsenrath, of Wall Street Journal, reflects on the details of the Fed's exit:

  • 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 big winners, he argues, are foreign banks, who earn nice returns from this band: borrowing from money market funds at or around ON RRP, and then placing it with the Fed at the IOER rate. Domestic banks cannot play this game because fees to the Deposit Insurance Corporation eat in the spread.

Two observations:

1. The band -  - the corridor set by the IOER rate and the ON RRP - under QE is functionally different from the band set by the standing facilities under 'normal' interest rate policy. In the latter case, the upper limit is set by the rate at which the central bank lends to commercial banks. Currently, both the upper and the lower ends are rates at which the central bank mops liquidity from the system. Hence foreign banks' behavior.