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Meet reverse repo: The new Fed tool to raise your interest rates

Fred Williams

The sun rises in the east, two plus two equals four, and the Federal Reserve sets interest rates through the federal funds rate target.

One of these bedrock certainties is getting tossed. A historic glut of cash in the economy is about to force changes in the way the Federal Reserve controls short-term interest rates. This hangs some uncertainty over the way banks will eventually raise their rates on consumers — including the variable APRs on millions of credit cards.

“The Fed’s balance sheet has never been this big,” said David Ely, an economist and finance professor at San Diego State University. “We’re in uncharted territory.”

New tools to raise interest rates could affect credit card APRs

The federal funds rate is the rate on overnight loans that banks make to each other, in order to meet reserve requirements. For decades it has been the Fed’s most powerful lever on short term interest rates.Consequently, it is also the Fed’s most important signal to markets, and the target has been announced publicly since 1994. Whenever in your life you have heard a newscaster say “The Fed has changed interest rates,” that was shorthand for “The Fed has changed the federal funds target rate.”

That’s because with rare exceptions, banks moved their prime rate — the benchmark for many  loans, including variable-rate credit cards — in lock step with the federal funds rate.

But since the 2008 financial crisis, the monetary world has flipped on its head. The Fed has held the target rate near zero while it pumped an unprecedented $4 trillion of cash into the economy to boost growth. Banks have not been willing or able to lend out most of that money, so it still sits on their books as reserves. With these ample reserves, banks don’t need to borrow more from each other, making federal funds ineffective as a rate-raising tool.

The Fed is aware of the problem and is looking for other levers to move interest rates. On Jan. 31, the Federal Reserve Bank of New York expanded its testing of tools called “reverse repurchase agreements” as a substitute for federal funds. The short-term financing agreements backed by Treasury securities are used as parking spots for cash, not just by banks but also by money market funds, increasing their power.

The idea is that the rate on these risk-free instruments from the Fed will set a floor for lending rates in the economy. Banks would see the rate they can earn on repos as a standard, and price their loans to consumers and businesses accordingly, by adding premiums to the Fed’s repo rate.

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For consumers, the shakeup of the monetary toolbox might not be noticeable. The changes are a technical issue that affect only financial players, said Joseph Gagnon, senior fellow at the Peterson institute for International Economics and co-author of an influential paper on new rate-setting tools. “Maybe the prime should be set a tiny bit higher — 10 basis points,” he said. “Would banks even bother with that?”

However, even slight changes in how interest rates are set could have widespread consequences. The Fed plans to begin raising rates in 2015 as the economy strengthens. With something like $800 billion in credit card balances subject to variable rates, household budgets are directly connected to decisions made at the Fed’s meeting table.  Every 1 percentage point increase in market rates will mean about $8 billion more a year in finance charges on card balances.

Merely speeding up changes in the rates consumers pay would have a pocketbook impact, for example. Since the mid-1980s the prime — taking its cue from announced changes in the federal funds target — moved a few times a year at most, in steps of a quarter-point. Quicker changes in bank benchmark rates would mean cardholders will see their interest costs — and minimum payments — rise more quickly.

The current rate-setting mechanism is not quite cast in stone, but it is certainly embedded in lots of credit card terms. Open your card agreement and you are likely to read that your APR can reset as often as once per billing period, based on the prime rate published in the Wall Street Journal. The prime, in turn, looks to the federal funds rate. A spokesman for the New York Fed said that the bank was not in a position to comment about how commercial banks might react to the change.

Gagnon, in his paper with Brian Sack, coordinator of global economics at the D.E. Shaw Group, wrote that “switching between benchmarks could present a difficult transition” for financial markets, which the Fed will need to manage.

Whether replacement monetary tools will even work “is a significant question,” Ely said. Trying to lift interest rates while piles of idle dollars sit in banks could have unexpected difficulties. “It’s never been tried before.”

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