In post-repo squeeze twist, Fed may nudge up interest paid to banks

By Jonnelle Marte

(Reuters) – One potential side effect of the U.S. Federal Reserve’s efforts to pump liquidity into the banking system and avoid further unwanted surges in short-term borrowing rates: The central bank may soon have to take measures to keep interest rates from getting too low.

Some economists and strategists expect the Fed to make a slight increase this week on the interest it pays on excess reserves held at the central bank, or IOER. The tweak would be viewed as a mechanical move aimed at lifting the effective federal funds rate, currently near the bottom of the Fed’s target range.

Raising the IOER could bring the effective funds rate closer to the middle of the Fed’s target range of 1.5% to 1.75%, said Zachary Griffiths, a rate strategist for Wells Fargo Securities.

Officials could bump up the IOER by .05 percentage points to 1.6%, which would put it above the current effective funds rate of 1.55%, Griffiths said.

Boosting the rate paid on reserves could encourage banks to demand higher rates when they lend money in the federal funds market, Griffiths said. But it would be viewed as a technical change that has no effect on monetary policy, he said.

“It doesn’t have broader implications,” Griffiths said.

Policymakers discussed the possibility of tweaking the IOER during the December policy meeting, minutes show.

“Should conditions warrant this adjustment, the IOER rate could move closer to the middle of the target range for the federal funds rate,” the Fed said in the minutes.

The increase would be a partial reversal from the Fed’s most recent adjustments to the IOER, which it has lowered four times since the middle of 2018.

With those moves, the Fed was working to lower the effective federal funds rate, which was at the high end of the central bank’s target range at the time, said Lewis Alexander, chief U.S. economist for Nomura.

Previously, reserves were declining, which put upward pressure on the effective funds rate, Alexander said.

In contrast, reserves have been increasing since the fall, when the Fed began purchasing Treasury bills to boost liquidity and stabilize rates after a spike in short-term borrowing costs.

There’s a chance the Fed may hold off on making the adjustment.

“We’re still relatively close to the disruptions of the fall,” Alexander said.

Some analysts say the effective funds rate may inch higher on its own. Treasury bill issuance is expected to increase in February and March, which could reduce the level of reserves and push up the effective funds rate, according to a note by Jefferies distributed to clients last week.

(Reporting by Jonnelle Marte; Editing by Bernadette Baum)