NEW YORK (Reuters) - Two-and-a-half years into its tightening cycle, the U.S. Federal Reserve is set to fine-tune a policy framework that was built in the shadow of the financial crisis but that may not hold as markets and banks continue to adjust in the years ahead.
The planned tweak appears small: minutes from this month’s meeting show Fed officials are prepared to leave one of its key interest rates 0.05 of a percentage point lower than usual when it next decides to tighten policy, likely in June.
The U.S. central bank’s key policy rate, the fed funds rate, usually hovers in the middle of a 0.25-percent range which shifts higher as policy tightens. But in recent months it has crept higher within that range, currently set at 1.50 percent to 1.75 percent, on some days hitting even 1.70 percent.
To view a graphic on Fed funds effective rate vs interest on excess reserves, click: reut.rs/2KWr6Ej
So in an attempt to nudge the fed funds rate back toward the middle, the Fed has sketched out a plan to set its effective upper bound, a rate paid on banks’ excess reserves and known as IOER, at 1.95 percent instead of 2.00 percent when it next decides to tighten policy.
“This is about protecting and maintaining full control of its single most important interest rate,” Torsten Slok, chief international economist at Deutsche Bank Securities, wrote in a client note. He added the Fed could continue to effectively narrow the policy range if the trend continues.
The Fed is reacting to a steady decline in banks’ excess reserves from about $2.7 trillion in 2014, when it set up the current policy framework, to less than $2 trillion now.
To view a graphic on U.S. banks' excess reserves at the Fed, click: reut.rs/2KTDOU9
As a multiple of required bank reserves, such excess reserves are near their lowest levels since the 2007-2009 crisis.
The Fed has contributed to the drop by shedding some of its own bond holdings since September. Putting further upward pressure on the fed funds rate within that range, new government spending caused a spike this year in U.S. Treasuries issuance that in turn has raised costs in the overnight repo market.
To view a graphic on Excess reserves vs the Fed's balance sheet, click: reut.rs/2KWcnsN
Since the Fed plans to keep trimming its portfolio, and fiscal stimulus will run well into next year, central bankers are already considering more wholesale adjustments to the way they control borrowing costs in the economy.
According to minutes of the May 1-2 meeting, a number of Fed officials suggested that, “before too long, the Committee might want to further discuss how it can implement monetary policy most effectively and efficiently when the quantity of reserve balances reaches a level appreciably below that seen in recent years.”
Reporting by Jonathan Spicer; Editing by Chizu Nomiyama