March 22, 2018
March FOMC Review
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FOMC Review Snapshot
- The Fed raised its key monetary policy rate, the interest on excess reserves (IOER) rate, to 1.75%.
- The rate hike comes despite no signs of overheating and inflation remaining below the Fed’s 2% target.
- However, Fed projections for a year-end 2018 IOER rate of 2.25% remained unchanged.
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Details
The Federal Open Market Committee (FOMC) unanimously voted to raise the interest on excess reserves (IOER) rate to 1.75%. The fed funds rate will now trade between 1.75% and an overnight-reverse repurchase (ON-RRP) rate of 1.50% (see Box 2 below). The Fed’s current normalization plans include raising its IOER rate, which fell to as low as 0.25% at year-end 2008, and gradually reducing the size of its balance sheet, which remains enlarged at $3.9 trillion. These compare with a 5.25% Fed interest rate target and a $0.8 billion balance sheet before the last recession and the introduction of IOER. (Fig. 1)
The inflation rate remains below the Fed’s 2% inflation target (Fig. 2), as measured by the core personal consumption expenditures (PCE) price index. The FOMC continues to project it will eventually rise to the target. Market-based measures of expected inflation[i] have ticked up recently but continue to indicate inflation will undershoot the Fed’s target over the next 10 years. This suggests that the economy is not “overheating” from tax reform. The fed funds futures market anticipates a second Fed IOER rate hike for 2018 will occur at the June 12-13 FOMC meeting.
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Context
A low unemployment rate and closed output gap (Fig. 3) would typically suggest the economy could not sustain faster growth. However, policies after the 2008-09 recession artificially constrained the economy’s potential by deterring workforce participation and businesses investment. Ongoing Administration and Congressional GOP efforts to regain the lost potential through pro-growth policy like the Tax Cuts and Jobs Act can enable faster growth without increased inflation, as occurred in 2017. Thus the Fed does not have to worry about the economy “overheating.”
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Box 1: The Federal Open Market Committee (FOMC)
The FOMC typically meets 8 times per year. It consists of the 7 governors from the Fed’s Board of Governors in D.C. (with 4 current vacancies), and 12 regional Fed bank presidents.
While all Fed governors have a vote on the FOMC, only 5 Fed bank presidents can vote. The New York Fed president is a permanent voting member, and 4 others can vote on a rotating basis.
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Box 2: IOER and ON-RRP
In 2008, the administratively determined interest on excess reserves (IOER) became the Fed’s key policy interest rate, supplanting a market-determined fed funds rate, which the Fed would influence by making small interventions in the fed funds market. The Fed pays IOER on funds banks keep on deposit with the Fed that might otherwise have been lent to consumers or businesses. All else equal, a higher IOER rate portends a tighter monetary policy, because it encourages banks to hold reserves rather than make more loans, which tends to slow inflation.
A much-reduced level of trading still occurs in the fed funds market because GSEs (government-sponsored enterprises like Fannie Mae and Freddie Mac) are ineligible to earn IOER. GSEs lend their idle cash to banks at the fed funds rate, which banks deposit to earn a higher IOER rate. To prop up the fed funds rate as the Fed raises the IOER rate, the Fed withdraws cash from the market by temporarily selling some of its securities for cash at its overnight-reverse repurchase (ON-RRP) rate, which sets a floor on the fed funds rate.
The continued existence of the fed funds market and the ON-RRP facility should not distract from the fact that the Fed now uses IOER as the key rate to conduct monetary policy.
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Noteworthy
Consistent with the above reasoning, the FOMC projection for IOER rate hikes for 2018 remains unchanged at 2.25% according to its new Summary of Economic Projections (SEP).[ii] A higher value would have implied the Fed was becoming more concerned about overheating despite inflation being little changed in recent months. Figure 4 illustrates the FOMC members’ median year-end projection in the SEP of real GDP (RGDP), inflation, the IOER rate, and nominal GDP (NGDP). Numbers above (below) the bars represent the highest (lowest) projection. Green (red) arrows represent numbers that have increased (decreased) since the most recent SEP.
[i] The 10-year “TIPS spread” measures expected inflation by taking the difference between the market yields on 10-year U.S. Treasury notes and 10-year Treasury Inflation Protected Securities. “TIPS” compensate holders for changes in money’s purchasing power as measured by the consumer price index, CPI. Historical data and the Congressional Budget Office’s average projections of 2.4% CPI inflation and 2.0% personal consumption expenditures (PCE) inflation over the next 10 years indicate that CPI overstates inflation by 0.4 percentage point on average. JEC adjusted the TIPS spread by subtracting 0.4 percentage point to make the measures comparable to the Fed’s preferred inflation indicator (PCE).
[ii] SEPs are only updated at FOMC meetings in March, June, September, and December; these do not contain projections of its balance sheet size.
