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The Short Answer

How Does the Fed Raise Interest Rates?

The mechanics will be different this time around.

Question: How does the Fed actually "raise" rates? What goes on behind the scenes?

Answer: Many investors understand some of the basic effects that rising interest rates have. Higher rates ultimately benefit savers, because rates on savings accounts, money markets, and CDs trend higher. But the prices of longer-dated bonds, which have an inverse relationship with rates, fall. Borrowing costs will rise when interest rates go up, too. That has an impact on businesses that borrow money to fund their operations and grow, and it also affects consumers as the rates on many consumer loans--such as home-equity loans, credit cards, and auto loans--tend to rise.

But the lesser-known element is what goes on behind the scenes when the Federal Open Market Committee decides to raise or lower its target interest rate. The Fed doesn't simply declare that a new higher or lower rate is in effect and leave it at that; rather, to achieve its monetary-policy goals, it uses the tools it has at its disposal to take action that results in changes in the rates we see in the market.

And this time, the actions it will take, and the tools it will use, will be much different from the ones it has used in the past.

The Fed's Traditional Tools
In the era before the financial crisis, the Fed would primarily influence rates in the market by adjusting the quantity of reserves in the banking system, which kept the federal-funds rate--the interest rate at which banks lend to each other overnight--around the target established by the FOMC.

One of the most common tools that the Fed used to accomplish this feat is what is known as "open-market operations"--in which the Fed buys and sells Treasury securities in the open market. When the Fed buys Treasuries, it pays the seller, which increases the reserves in the banking system. The more plentiful banks' reserves, the more money is available to loan, which puts downward pressure on the federal-funds rate. When the Fed is selling securities, conversely, it is reducing reserves in the banking system (because the buyers are paying the Fed for the assets), raising rates. (For more on this, see this article from the St. Louis Fed.)

The goal of open-market operations was to set the quantity of reserves in the system equal to the quantity demanded by the banks at the target rate of interest, explains Julian Potenza, a macro/asset allocation analyst at Fidelity. "By making precise adjustments to the quantity of reserves in the system, the Fed was able to exercise very tight control over the federal-funds rate and was able to keep that market perfectly balanced so that the quantity of reserves in the system was exactly the same as banks' demand at the Fed's objective target interest rate," Potenza said.

Why It's Different This Time Around
Today, the Fed's balance sheet looks much different from how it did prior to the financial crisis. After purchasing trillions of dollars of assets as a result of quantitative-easing programs, the size of the Fed's balance sheet is now around $4.5 trillion, as opposed to in the $800 billion range prior to the crisis, Potenza said.

The effect of the Fed's asset-buying programs is that the financial system is awash with reserves, and this delicate balance is a thing of the past. The Fed likely doesn't want to sell the assets on its balance sheet immediately--presumably, because it doesn't want to unravel everything that was accomplished by quantitative easing in the first place. Selling too many financial assets in too short a period of time could put too much upward pressure on interest rates and cause financial conditions to tighten too much, and could have a destabilizing effect on the bond market.

So, the Fed is now faced with a new challenge: It needs to raise short-term rates in the market without selling its own securities holdings, and without reducing the level of reserves held by banks.

Indeed, the Fed said earlier this year that it intends to achieve its target range for the federal-funds rate "not by actively managing the Federal Reserve's balance sheet." Rather, it will use some new tools this time, which it said will allow it to raise short-term interest rates and "to maintain reasonable control of the level of short-term interest rates as policy continues to firm thereafter," even though the level of reserves held by banks is likely to diminish only gradually.

The New Tools
Since October 2008, the Fed has been paying banks interest on their reserve balances. According to the Fed, increasing the rate of interest paid on excess reserves, or IOER, will be the primary means of raising the federal-funds rate when a decision is made to raise the target range. Currently, this rate is 25 basis points (or 0.25%), and it is expected that this rate will go up to 50 basis points when the Fed decides to raise rates.

"Instead of setting the fed-funds rate by adjusting the quantity of reserves in the system, they've decided to put a price on those reserves directly by paying banks, currently, 25 basis points for the reserves that they hold," Potenza said.

The idea behind the interest on excess reserves is that it would put a "floor" on short-term rates; banks would not be expected to lend to a higher-credit-risk counterparty at less than the 25-basis-point rate it could earn for lending to the Fed, which is a riskless counterparty.

And that certainly makes sense; however, there are plenty of nonbanks that would lend for less. The IOER is only available to "depositary institutions"--in other words, banks. It's not available to nonbank institutions that are significant lenders in the financial system, such as money market funds and government-sponsored enterprises (GSEs).

"The IOER was providing a very leaky floor for the Fed to be relying on as a tool to raise rates. The core reason for that was because it was only available to a subset of counterparties, namely the banking system," said Potenza.

Reinforcing the Floor
To address this problem, the Fed plans to use another tool known as overnight reverse repurchase agreements, or "reverse repos." In an overnight reverse repo operation, the Fed is essentially allowing nonbank counterparties (GSEs or money market funds, for example) to make collateralized loans to the Fed at a fixed interest rate.

In theory, reverse repos (RRPs) should work the same way as the IOER rate to set a floor under short-term interest rates, because they would discourage loans to riskier counterparties at less than the RRP rate. The RRPs, in combination with the IOER, should then, theoretically, reinforce the short-term rate floor.

Currently, this RRP program has an aggregate cap of $300 billion, but the Fed has indicated that it would be willing to expand the program if necessary. The key, according to Potenza, will be to supply RRPs in sufficient quantity. "If they don't size it right relative to the demand, it might not serve as the kind of firm floor that they were hoping for."

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