Fed Rate Veering Closer to Zero Adds Fuel to Debate Over Tweaks

(Bloomberg) -- The key benchmark that the Federal Reserve targets to control monetary policy slipped closer to zero, raising the possibility that the central bank might need to tinker with the tools it uses to control it.

The shift also adds to the debate about policy more broadly, as the glut of cash that’s keeping downward pressure on short-end rates combines with longer-term inflation concerns to fuel talk about just how soon the Fed might need to take its foot off the accelerator.

The effective fed funds rate, which the central bank is currently aiming to keep within a range of 0% to 0.25%, slipped by 1 basis point to 0.05% on May 28, the lowest since April, the Fed said Tuesday. A persistently lower level raises the chance that the bank will tweak the rates it sets for interest on excess reserves and its reverse repurchase agreement facility.

An adjustment to these so-called administered rates is likely this month, Wrightson ICAP economist Lou Crandall said in a note before the most-recent fed funds figure was published, but there’s less of a chance the bank will make a balance-sheet adjustment “to address the root of the problem.” He also sees it potentially being smaller than similar prior tweaks.

The minutes of the last Federal Open Market Committee meeting noted that downward pressure on overnight rates in coming months could warrant consideration of a modest adjustment to administered rates.

Taper Talk

The next Fed policy meeting is scheduled for June 15-16, and investors will be watching not just for tinkering of administered rates, but also for indications about when officials might begin to taper their bond-buying program and ultimately lift benchmark rates.

The drumbeat of policy makers making noises about when the Fed should debate tempering its asset purchases has been quickening, although officials have been careful to say that their views are premised on the economy continuing to power forward and the prospects for sustained inflation.

Some market participants are not convinced the central bank will need to adjust its tools quite yet and need to see the fed funds rate holds steady at the current level after month-end pressures have subsided.

“I’ve been really keying on that effective rate, and I don’t really put any stock in data from month-end/quarter-end,” said Jefferies economist Thomas Simons. “I really need to see tomorrow’s numbers. And remember that we could have an adjustment intermeeting as well.”

Fistfuls of Dollars

Bond traders, meanwhile, are keenly attuned to the buildup of dollars in short-term interest-rate markets, an overabundance reflected in the almost half a trillion dollars sitting and earning absolutely nothing at the Fed’s reverse repo facility.

Volumes at the so-called RRP Tuesday fell for the second straight session after demand reached an all-time high last week. Forty-three participants took $448 billion, which was below Friday’s takeup of $479.5 billion, New York Fed data show.

For some, that’s yet another sign that the so-called quantitative easing program ought to be dialed back from its current pace of $120 billion a month. Others say it’s a separate matter and that the central bank facility is acting like it should, as a safety valve, while also pointing to the other factors fueling the cash oversupply.

For his part, Crandall says there’s an argument for the Fed to adjust the maturity mix of its asset purchases to relieve some of the short-end strains. Although the Fed has shown little interest in a “Twist-like combination” of long-end buying and short-end runoffs, he wrote.

“There is no fundamental reason why the Fed should be sitting on more than $1 trillion of Treasuries maturing within one year at a time when nonbank investors are so starved for short-end assets that money funds are forced to recycle half a trillion dollars of surplus cash back into the RRP facility,” Crandall wrote.

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