With a quantitative easing exit now being eyed, many are beginning to worry about the possibility that the Federal Reserve will struggle to unwind its huge balance sheet in a controlled way. In reality, however, there is no reason to fear runaway rates provided authorities keep collateral market rates in mind during the exit process.
Among the unconventional tools the Fed introduced during the peak of the crisis was a “floor” mechanism known as “interest on excess reserves”. Less high profile than other unconventional policies such as asset purchases, IOER’s role in controlling rates has been under-appreciated by the market. Indeed, it is because of IOER that liquidity has been reabsorbed into the central bank system so efficiently. Above all, IOER has played an important role in ensuring that short-term rates did not fall too far below the critical floor of 0.25 basis points, despite all the additional liquidity that was pumped into the system.
Contrary to popular understanding, the Fed has in this sense been propping up the short-term rate market, not suppressing it. IOER’s power to steer rates could now be used to help manage money-market rates during the exit process. But IOER’s ability to influence money market rates for depository institutions has come at a cost. The short-term rates market is increasingly bifurcated, as it is only depository institutions that can really benefit from these freely distributed positive rates.