As the U.S. economy starts to look better, the Fed eventually has to increase its federal funds rate. The Fed has stated that it is planning to keep the near zero federal funds rate until the unemployment reaches 6.5 % as long as the inflation rate and expected inflation remains low.
Now, the question is whether the Fed will be able to increase the short term rate in the economy as it desires when the correct time comes through changing its federal funds target rate. As the Fed has been conducting QEs since the recession ended, its balance sheet reached $4 trillion mark in last December and bank reserves at the Fed increased greatly.
- Source: http://www.piie.com/publications/pb/pb14-4.pdf
To increase the short term interest rate in the future, under current system, the Fed has to sell government bonds to pull money out of the economy, therefore increases the interest rate. But since it has put in enormous amount of reserves for last few years, the Fed faces a problem of selling huge amount of asset to effectively increase the interest rate.
Since September 2013, the Fed has been experimenting a new tool to control the short term interest rate. This new tool called a reverse repurchase program works this way: the Fed sells its asset in the System Open Market Account to money-market mutual funds, banks, securities dealers, government-sponsored enterprises and others with a condition that it will buy back those assets in the future for higher price than it sold to them. In other words, the Fed, under this program, borrows from those institutions with collateral of Treasury Securities. The difference between the sale price and repurchase price along with a length of time between these indicate the interest rate the Fed pays.
When the Fed wants to increase short term rates, it can increase the reverse repurchase interest rate. When the financial institutions see this higher interest rate paid buy the Fed, they aren't willing to borrow reserves each other below this rate because they can make more buy purchasing assets from the Fed and selling back. Therefore, it can effectively put a floor for the short term interest rates that banks charge each other. Moreover, through raising this rate, the Fed can affect the overall short term interest rate in the economy. Also, using reverse repurchase program, the Fed doesn't have to shrink its balance sheet; therefore, it can use its assets when it faces a problem.
One counterproductive effect this program could have is that when the Fed shifts to this policy, the Fed will be expanding the monetary base through its payment to financial institutions. That is reverse of what the Fed tries to do when it needs to raise the interest rate in the economy.
Along with targeting reverse repurchase interest rate, the Fed has to increase the interest on reserves, which is currently 0.25%, when it raises the short term interest rate to prevent depository banks from lending too much credit and causing inflation.
This policy has been examined by the Fed since September, and there has been a research paper on its effectiveness. Whether the Fed will employ this policy in the future is interesting thing to put eye on.
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