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Fed mulls system to raising rates

Friday, May 30 12:19:23

Don't count on the U.S. Federal Reserve to go back to a numerical bulls-eye to aim at when it finally decides to raise interest rates. A target range for the federal funds rate may well be here to stay, at least for the foreseeable future.

While the liftoff for rates is likely a year or more away, Fed officials already have devoted a lot of thought to the mechanics of how they pull off that move.

It's a delicate issue for the central bank.

The Fed has flooded the financial system with $3.4 trillion, and $2.6 trillion of that has ended up back at the Fed as excess bank reserves. With that much money of their own, banks have little need to borrow from each other in the federal funds market to meet the Fed's daily reserve requirements.

As a result, the market has lost some relevance and liquidity, causing a few Fed officials to reconsider the idea of reverting to a specific federal funds rate target any time soon.

"My view is it would be perfectly appropriate potentially in the early part of the interest-rate hike period to just move that range up, and recognize that at least for a while it's going to be hard to hit a specific number," San Francisco Fed President John Williams told reporters last week in Dallas.

And even though since December 2008 the target for the federal funds rate has been a range of between zero and 0.25 percent, rather than a specific figure, most primary dealers who deal directly with the Fed still expect the Federal Open Market Committee to raise it back to a single number when the time comes, according to Reuters polls.

They may be surprised then should the Fed choose not to abandon the range just yet, as some like Williams have suggested.

The Fed's first rate increase may well be to a range of perhaps 0.25 percent to 0.50 percent instead of a jump to say 0.50 percent, according to Williams, who will be a voter on the FOMC next year when the rate-rise question will be front and center.

To be sure, some other Fed officials still prefer a single target for the fed funds rate for clarity and ease to guide the market. It also makes easier for traders who use the fed funds rate as a benchmark for other short-term rates and derivatives.

In addition to being the rate banks charge each other for overnight loans to meet the Fed's reserve requirements, the fed funds rate is an important reference point used to determine other borrowing costs, such as the prime rate, which banks charge their most creditworthy customers.

If a higher rate range is adopted and ends up confusing the market, it could disrupt overnight lending markets, hurt the Fed's credibility and harm the economy, analysts said.

"The mechanics of policy tightening is still a tricky issue for the Fed," said Millan L. Mulraine, deputy head of U.S. research and strategy at TD Securities in New York.

This quandary on setting rate targets seems part of a broader policy debate within the Fed whether it should abandon the fed funds rate altogether.

Dallas Fed President Richard Fisher said this month "the fed funds rate is not the right tool going forward" given the others available. That echoes a high-profile paper co-authored by Brian Sack, the former New York Fed markets chief, that suggested a new tool known as overnight fixed-rate reverse repurchase agreements should supplant fed funds as the Fed's primary policy tool. (Reuters)