Federal Reserve weighs options on how to raise US rates

How do you persuade people to pay for the air they breathe? That is the problem the US Federal Reserve is wrestling with, as it tries to figure out how it will eventually raise interest rates, after its quantitative easing programmes left banks saturated with reserves.

In the past, the Fed raised rates by reducing the supply of bank reserves. Banks have to hold a minimum level of reserves, so when the supply fell, they would pay more to borrow them - and then pass that rate on to their customers. The supply of reserves was like oxygen underwater: an essential commodity in limited supply. The market interest rate for borrowing bank reserves overnight is known as the Fed Funds rate. Such was the Fed's experience at managing this market, that the Federal Open Market Committee could decree a rate, and then the New York Fed's markets desk would fine tune the supply of reserves to hit it precisely.

Today, the situation is different: after three rounds of quantitative easing, banks have reserves at the Fed almost $3tn greater than the regulatory requirement. Reserves are everywhere, like air above water: no bank needs to borrow them. The Fed could suck out a bit of oxygen and it would not make any difference to the price.

The main tool the Fed will use to raise rates, therefore, is the interest it pays to banks on their excess reserves. So-called IOER is currently set at 25 basis points. If it puts IOER up to 50 basis points - in essence paying more for all the oxygen in the banking system - then banks will not lend to anybody else for less. That means the Fed already has the only tool it needs to control broad financial conditions.

But there is still a problem because not every market player can deal with the Fed. That means market interest rates, such as Fed Funds, will not necessarily track the IOER rate. For example, the current Fed Funds rate is 0.09 per cent, and it has fluctuated between 0.07 and 0.20 per cent over the past few years. Given the Fed expresses its policy as a target for the Fed Funds rate, it is extremely uncomfortable for the central bank to have it out of its direct control.

The Fed is therefore considering a range of extra tools that will allow it to exert more control over market interest rates. It debated these tools at its April meeting and instructed the New York Fed to step up tests on a range of experimental facilities. All of these facilities have advantages and disadvantages but one - a device lugubriously called the Overnight Fixed-Rate Reverse Repurchase facility (ON RRP) - has emerged as a clear favourite.

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