**MNI INTERVIEW:Fed's IOER Tweak Foreshadows Broader Reckoning

--Longer Run Issues on Policy Implementation on Horizon

--FFR Market Dynamics Could Shift When Reserves Dip Below $1T, Fed Economist

Says

By Jean Yung

     WASHINGTON (MNI) - Concerns are rising that the Federal Reserve's grip on

its benchmark rate is loosening, but officials aren't yet facing an immediate

need to reform their policy implementation framework, Philadelphia Fed Bank Vice

President and economist Roc Armenter told MNI in an exclusive interview. 

     The Fed surprised markets Wednesday by proposing an unexpected change to a

key monetary policy tool, but left the broader discussion over future operating

procedures for a later time. The Federal Open Market Committee said it could

soon decouple the interest paid on excess reserves from the upper bound of the

target range and effectively deliver a 20 basis point rate hike to ensure the

effective fed funds rate remains within the target range. MNI, in an analysis

piece on May 1, flagged the possibility of such a move. 

     With fresh breathing room, the central bank likely has several quarters to

address the longer run issues surrounding policy implementation, Armenter said,

giving it time to assess how the Fed's shrinking balance sheet and evolving

demand for bank reserves impact money market conditions.

     Any reforms may go hand in hand with a determination on the ultimate size

of the balance sheet. That in turn is influenced by the level of banks' long-run

demand for reserves, something the Fed has yet to get a "definitive handle" on,

Governor Randy Quarles said May 4. 

     --SCARCER RESERVES

     Armenter and co-authors argued in a recent paper that a shift in market

dynamics could push the fed funds rate above IOER when the amount of reserve

balances held at the Fed dips below $1 trillion. Arbitrage trades currently

dominate activity in the fed funds market, but Armenter believes bank-to-bank

loans could dominate trading once reserves become sufficiently scarce. 

     Reserves currently stand at $2.0 trillion but are contracting as the Fed

reduces its balance sheet.  

     "Nothing says bad things will happen if the (effective) fed funds rate goes

above the IOER, but technically speaking we'll lose interest rate control,"

Armenter said. 

     "As soon as there's more demand by small- to medium-size banks for

liquidity purposes, larger holders of reserves could be looking to lend them

rather than to borrow. That can happen quite quickly when reserves are somewhere

south of $1 trillion," Armenter said.

     At that point, the effective fed funds rate could drift above IOER,

prompting the FOMC to either halt the balance sheet normalization process or to

rethink the current implementation framework, he said. 

     --SMOOTH SAILING 

     Armenter attributed last month's run-up of the effective fed funds rate to

1.70%, just 5 basis points below the top of the target range due to heavy

issuance of Treasury bills which also led to higher repo rates. 

     "I don't see as much upward pressure on rates since April, and it does look

like the situation has stabilized," Armenter said. Since the situation came

about "not because reserves are scarce, it shouldn't be adding extra pressure

anytime soon." 

     Surveyed by the New York Fed in late April, primary dealers indicated they

see the spread between the fed funds rate and IOER staying put at 5 basis points

through year-end but narrowing to 2 basis points by December 2019. 

     Accordingly, many FOMC officials judged at their May meeting it could be

useful to set IOER modestly below the upper bound of the target range as a

purely technical adjustment. 

     "Clearly 5 basis points qualifies as a 'small' adjustment but, in my

opinion, it would be sufficient for the time being," Armenter said. 

     Potential upside risks to fed funds rates later this year include the

possible elimination of FDIC fees or a renewed surge in T-bill issuance, but,

"In my view, the top of the range, with the potential adjustment to IOER, would

withstand most of the risk scenarios," he said.  

     --DEMAND FOR LIQUIDITY

     For the effective fed funds rate to trade substantially above IOER, the

market would need to experience a substantial liquidity demand by banks, a

complex issue Fed economists are studying. But upward pressure on the fed funds

rate is a key indicator that reserves are becoming scarce. 

     "We're going to allow the market to tell us through a gradual change in the

environment," Quarles told a Hoover Institution conference on monetary policy in

Stanford, Calif earlier this month. "As that balance sheet shrinks, we will hit

the point of the underlying demand for bank reserves, which right now is not

clear. And we will see it when we see it." 

     According to the May FOMC meeting minutes, "A number of participants also

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." 

     For now, the Fed may be more than a trillion in assets away from that

happening.

--MNI Washington Bureau; +1 202-371-2121; email: jean.yung@marketnews.com

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