Jackson Hole: Ask Not How Many Rate Hikes, but Whether Target Rates Can Be Maintained

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The annual Federal Reserve symposium at Jackson Hole, Wyoming, starts on Friday, and Fed watchers are pulling out their binoculars. Fed Chair Jay Powell is set to speak in the aftermath of being publicly criticized by President Trump for raising interest rates, adding another juicy element to what is always a closely followed central banker event. Fed watchers are having another day in the sun, anxious to pick apart the upcoming speech for any hints of how many rate hikes are planned for the rest of decade.

But perhaps counting potential rate hikes is the wrong focus. There looks to be a more fundamental issue at play here, and that is whether the Fed can even keep the effective federal funds rate, considered the most powerful interest rate in the world, within its target range. Never before has the Fed actually lost control of the overnight rate, and if it ever did, nobody knows how markets would react. Still the overnight rate has been creeping inexorably closer to the upper boundary since late 2016, when the effective rate first consistently broke within 10 basis points of the upper boundary.

Important to remember is that the Fed does not control the overnight market rate by fiat. It has no authority to prevent banks from lending to one another at rates outside of its target range. It only maintains the range by daily adjustment of the amount of available liquidity in the banking system through the buying and selling of short-term paper.

Since August 16, however, the overnight rate has crept up a single basis point to 1.92%, within 8 basis points of the upper boundary. The last time this happened back in June, it briefly caught the attention of financial media, which began speculating that the Fed would in turn be forced to stop shrinking its balance sheet in order to bring the overnight rate back down. However, the rate quickly fell back down to 1.91% on its own after a week and the media lost interest. Now it’s back up again, and the Wall Street Journal has taken notice.

Not only that, but he Fed itself is paying attention, as is clear from the August 22 Fed minutes release:

Over the days following the June FOMC meeting, the effective federal funds rate (EFFR) moved up relative to the IOER [interest on excess reserves] rate [of 1.95%], reportedly reflecting some special factors in the federal funds market, including increased demand for overnight funding by banks in connection with liquidity regulations and a pullback by Federal Home Loan Banks in their lending in the federal funds market. These developments proved temporary, and the EFFR subsequently returned to a level about 4 basis points below the IOER rate (1.91%).

The Fed will certainly take notice this time again, but since we were at 1.92% before in June, alarm bells won’t go off unless it ticks up another basis point. If it does, expect stories on the end of the Fed’s balance sheet shrinking program to abound, which could weaken the dollar and possibly start the reversal of the ongoing emerging market currency collapse.

Also of note is that at the New York Fed website of daily overnight rates, the highest rate being paid was actually 2.10% on August 20, a full 10 basis points higher than the current upper boundary. This goes to show indeed that the Fed cannot stop any given bank from breaking its self-prescribed upper boundary. While this is not unprecedented, it is very rare. The highest rate being paid for overnight funds has been 10 basis points or more above the upper boundary for only 20 business days since 2011, or about 1.17% of the time.

The closest the overnight rate has ever gotten to the upper boundary was 5 basis points, which has never happened until this year. The next rate hike will not be until September 26 at the earliest, which means the Fed has to try and keep the effective rate within its current boundaries for another month. They’ll probably succeed, but the question is how big will the buffer be, and if the effective rate gets too close to the upper boundary this time, will the Fed decide to end its balance sheet shrinking by the next FOMC meeting? Stay tuned.