It's August. The first interest rate hike in eight years by the federal reserve could be just a month away.
While the topic of when the Fed will raise rates gets a lot of attention, that's the easy part of the equation. All they have to do is make a motion to implement policy changes that will try to peg short-term interest rates to 0.50%. It's a snap!
But then comes the hard part… figuring out the mechanics necessary to make that happen.
This used to be a simple task. The Fed would set the rate at which banks lent money to each other overnight, called the Fed Funds Rate (FFR).
This is essentially the interest rate upon which all other U.S. interest rates are based. Raise it, and others tend to follow. But now, thanks to a different Fed policy, the FFR is irrelevant. That could make raising rates difficult.
By printing trillions of dollars out of thin air, and using them to buy mortgage-backed securities and Treasury bonds from banks, the Fed left those banks with buckets of cash. Left to their own devices, banks might've tried to lend out the extra bucks, potentially driving inflation to the moon.
To stop such a trend before it started, the Fed created an incentive for the banks to hold their excess reserves at the central bank – paying them interest, literally known as “interest on excess reserves,” or IOER.
The Fed already institutes a minimum reserve requirement that banks must hold with them. But compared to the excess reserves, the minimum reserves seem like nothing.
Before the financial crisis, banks held the bare minimum required at the Fed. Those reserves amounted to roughly $60 billion at the end of 2007.
Today, the minimum required reserves are closer to $100 billion, but banks hold an additional $2.7 trillion in excess reserves at the Fed, on which they earn interest.
By encouraging banks to store these reserves, the Fed achieved its goal of keeping the cash out of the banking system and therefore the economy, but there was a side effect: Banks no longer needed to borrow money from each other. That means changing the Fed Funds Rate – its primary tool for raising interest rates – will have a limited effect, if any, on banks and the banking system.
