Fed may need to update its interest rate guide

Sun May 18, 2014 1:06am EDT
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By Richard Leong

NEW YORK (Reuters) - Interpreting Federal Reserve policy is hard enough, but the central bank may need to dust off its 'How to' guide to explain the nuts and bolts of new tools it will use when it finally starts to raise interest rates.

Traders and analysts in the past were accustomed to just glancing at the traditional federal funds rate. But managing that rate was easier when the banking system had about $800 billion in excess cash. With $2.5 trillion in reserves, the Fed's ability to control that rate is much harder.

The Fed has to look elsewhere to mop up reserves easily without causing dislocations. Now it has the TDF, RRP and IOER. Or rather, the term deposit facility, reverse repurchase agreements and interest on excess reserves - the three other programs that the Fed has signaled it will use when it attempts to normalize interest rates.

If successful, the combination of all three, along with how the Fed controls the fed funds rate, will usher in a new policy regime instead of the ultra-loose one it has clung to for the last five years.

But if this confuses investors, analysts fear the Fed could lose credibility and harm markets and the economy.

"The Fed is fumbling and working its way through it," said Eric Green, global head of rates and currency research at TD Securities in New York.

Most U.S. short-term market rates have been stuck in the single-digit to high-teen basis-point range since the Fed adopted its near-zero rate policy in December 2008.

The daily fed funds rate has averaged anywhere from 0.06 percent to 0.25 percent since January 2009, Fed data show. That hasn't mattered, because the Fed had no intention of moving rates during this extraordinary period of monetary policy.   Continued...

A view shows the Federal Reserve building on the day it is scheduled to release minutes of the Federal Open Market Committee from August 1, 2012, in Washington August 22, 2012. REUTERS/Larry Downing