MNI INTERVIEW: KC Fed's Smith Says IOER Could Be Cut Again

By Jean Yung

     WASHINGTON (MNI) - The Federal Reserve may further lower the interest on

excess reserves to maintain control over its benchmark rate if the decline in

the central bank's reserves continues to push money market rates higher, Kansas

City Fed economist Lee Smith said in an interview.

     The FOMC surprised markets by lowering IOER by another 5 bps last week in

an effort to keep the effective fed funds rate trading near the midpoint of its

2.25% to 2.50% target range. Fed Chair Jay Powell said last week he doesn't

anticipate another such adjustment but that the central bank will use its tools

as needed to control the fed funds rate.

     The EFFR first breached IOER only little more than a month ago. While Fed

officials have tended to blame factors such as rising Treasury issuances or, in

the most recent case, broad shifts in accounts to pay tax bills, Smith argues

that upward pressure on the fed funds-IOER spread is a direct result of

declining reserve balances.

     Reserve balances are at a fresh post-crisis low of $1.4 trillion or about

half of their peak in 2012. EFFR hit a high of 2.41% Thursday before retreating

to 2.40%, 5 bps above IOER.

     "In principle, the fed funds rate could go however much higher above IOER,"

Smith said. "One thing that we've learned about the (abundant reserves)

operating framework is it's proven to be pretty flexible. There's no obvious

challenge posed by letting the reserves rate decline and the fed funds rate

drift higher."

     --VOLATILITY AND DISRUPTION

     The fed funds rate now moves very little day-to-day, but prior to the

financial crisis, 5-basis-point daily gyrations were the norm, Smith noted. And

as the fed funds rate drifts away from IOER, he expects volatility to creep

back.

     "There's three choices here: the EFFR-IOER spread, reserve balances, and

IOER. And essentially policymakers can choose two of those things," he said. "If

they have a view about what the EFFR-IOER spread should be, then that will put

some limit on how low reserves can go."

     Reserves are set to shrink until policymakers decide they have reached the

minimum level needed to effectively implement monetary policy. After Treasury

runoffs end in September, organic growth in currency and other non-reserve

liabilities as well as the continued shedding of mortgage backed securities will

eat away at the reserves pool very slowly.

     With the difference between IOER and the overnight reverse repo rate now

narrowed to just 10 bps, analysts also worry that further compression of the

spread could lead to market disruptions.

     They fear that market plumbing might break down if IOER were cut to a level

near the rate the Fed pays on overnight RRPs. If the fed funds rate subsequently

fell to the same level as the administered rates, government-sponsored

enterprises might prefer to park their cash at the Fed rather than making

unsecured loans to the banking system.

     That could cause traded volumes to slump and spark erratic behavior in the

published median fed funds rate.

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

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