The path ahead
While commenting on the path ahead of the Fed, Charles Evans talked of certain exit principles that the Fed should follow, including the following.
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The new tools that would come into play are as follows.
Interest on excess reserves (or IOER)
Holding excess reserves entails an opportunity cost if higher risk-adjusted interest can be earned by putting the funds elsewhere. For banks in the U.S. Federal Reserve system, this is accomplished by making short-term (usually overnight) loans on the federal funds market to banks that may be short of their reserve requirements. To encourage more bank lending, the Fed simply needs to reduce this IOER rate, making the “park your excess funds with the Fed and earn an IOER” choice less attractive to lending.
The reverse repurchase agreement (or RRP facility)
A reverse repurchase agreement, also called a reverse repo or RRP, is an open-market operation in which the Fed sells a security to an eligible RRP counterparty with an agreement to repurchase that same security at a specified price at a specific time in the future. The difference between the sale price and the repurchase price, together with the length of time between the sale and purchase, implies an interest rate paid by the Federal Reserve on the cash invested by the RRP counterparty. This facility can be used to manage short-term interest rates, regardless of the size of the Federal Reserve’s balance sheet.
Term deposits will facilitate the implementation of monetary policy by providing a new tool through which the Federal Reserve can manage the aggregate quantity of reserve balances held by depository institutions. Funds placed in term deposits are removed from the accounts of participating institutions for the life of the term deposit, thereby helping drain excess reserve balances from the banking system.
For investors in ETFs, the performances of popular exchange-traded funds (or ETFs) like the SPDR S&P 500 ETF (SPY), the iShares Core S&P 500 ETF (IVV), and the iShares S&P 100 ETF (OEF), which track the large-cap equities of companies like Apple Inc. (AAPL) and Exxon Mobil Corp. (XOM), serve as a good indicator of the course the U.S. economy is taking.
To learn more about the Fed’s policy, see the Market Realist series Why the US labor recovery supports equities and high yield credit.