(Adds quote, background, graphic)
NEW YORK, Aug 22 (Reuters) - The latest increase in the federal funds rate will likely pressure the Federal Reserve to offer more guidance about the reduction of its balance sheet, according to a Bank of America Merrill Lynch analyst.
The effective, or average, interest rate on the fed funds (EFFR) was 1.92 percent for a fourth straight day on Tuesday. Its spread against the interest the U.S. central bank pays on excess reserves (IOER) stands at 3 basis points, compared with 4 basis points a week ago.
The smaller gap between the fed funds rate and IOER renewed a debate over whether the Fed’s reduction of its massive bond holdings, which started in October 2017, has made it more expensive for banks to borrow excess reserves to meet regulatory requirements or fund their daily needs.
“The EFFR increase also increases pressure on the Fed to provide guidance as to how far and under what conditions they might stop their balance sheet unwind,” Bank of America Merrill Lynch rates strategist Mark Cabana wrote in a research note released on Wednesday.
Excess bank reserves are projected to decline by $250 billion to $300 billion by year-end stemming from the Fed’s balance sheet reduction program, Cabana wrote.
In June, Fed policy-makers tweaked the increase the Fed pays on excess reserves, raising it by 0.20 percentage point to 1.95 percent, while they increased the top end of the target range on the fed funds rate by 0.25 point to 2.00 percent.
They adjusted this rate differential to discourage banks from borrowing reserves at the lower fed funds rate and profiting on the higher IOER by leaving the reserves at the central bank. The tweak’s goal is to encourage banks to lend rather than playing the rate arbitrage.
The Fed focuses the fed funds rate, or the overnight borrowing costs banks charge each other to borrow excess reserves, to conduct its monetary policy.
The central bank’s current target range on the fed funds rate is 1.75 to 2.00 percent. Analysts widely expect the Fed to raise its interest rate target by a quarter point to 2.00 to 2.25 percent at its Sept. 25-26 policy meeting.
Bank of America’s Cabana said the latest increase in the effective fed funds rate stemmed from higher borrowing costs in the repurchase agreement (repo) sector, hefty Treasury bill supply and lower trading volume in the fed funds market. It will likely fall in the coming days back to 1.91 percent.
The Fed will likely adjust IOER in December, Cabana said.
Reporting by Richard Leong Editing by Susan Thomas