Fed’s Tightening Cycle
A tightening cycle is a cycle of interest rate hikes. The Fed tightens its monetary policy by raising the federal funds rate to curb inflation if it is rising too quickly. In normal times, the U.S. central bank controlled theby changing the supply of reserves via open market operations. When the Fed wanted to raise rates, it would sell securities, which led to a reduction in reserves in the banking system. As the reserves become scarcer, the interest rates increase. However, because of the Fed’s quantitative easing programs, the banks became awash with reserves, so they do not need to borrow funds from each other as they used to before the financial crisis. It means that to raise interest rates by open market operations, the Fed would need to unwind all of its earlier purchases (around $3.6 trillion since 2008). Therefore, the U.S. central bank has been using two other tools during its tightening cycle started in December 2015: interest on excess reserves (IOER) and reverse repurchase operations (RRP).
Interest on Excess Reserves (IOER)
The interest on excess reserves is the interest paid on funds held at the Fed in excess of what is required (excess reserves are bank reserves in excess of a reserve requirement set by a central bank). The Fed began paying interest on excess reserve balances, as well as required reserves, in October 2008 thanks to the Emergency Economic Stabilization Act of 2008. According to the FOMC, the IOER would be the primary tool for raising the federal funds rate, since it puts a “floor” under the main Fed rate, as no bank would want to lend money to other banks at lower rates than they may get safely parking cash at the Fed.
Reverse Repos (RRP)
However, there is a notable problem with IOER. It does not create a perfect floor since it is only available to depositary institutions (among other problems), which do not have accounts with the Fed, so they would lend money for less. This is when the reverse repurchase operations enter the scene. In the RRP, the Fed sells securities to non-banks (such as money market funds) and agrees to buy it back the next day at a specified price. In essence, the U.S. central bank takes an overnight collateral loan, which also puts a floor under the federal funds rate, as no investor would lend money to commercial banks at a rate lower than what the Fed is willing to pay in the RRP. As one can see, the main difference between these two interest rates are different eligible entities. Since the investors who can participate in the RRP are the same ones who might undercut IOER, the changes in both rates should push up the federal funds rate.
Fed’s Tightening Cycle and Gold
It is widely assumed that the gold price must decline when the Fed hikes interest rates. However, this assumption is not supported by empirical evidence. As one can see in the chart below, there is no strict correlation between the federal funds rate and the price of gold, and there were many cases (as in the 70s or during the 2004-2006 cycle) when the tightening cycle was accompanied by upwards moves in the price of gold. However, real interest rates are much more important for the price of gold than the federal funds rate.
Chart 1: The effective federal funds rate (green line, left axis, in percent) and the price of gold (yellow line, right axis, London P.M. Fix) from 1968 to 2015.
In December 2015, the U.S. central bank raised IOER to 0.5 percent, while the overnight RPP rate rose to 0.25 percent (it also increased the discount rate to 1.00 percent). That is, the rate charged on loans the depository institutions receive from the Fed’s lending facility, which creates the “ceiling” on the federal funds rate, since no banks should want to borrow money from other banks at a higher rate than from the U.S. central bank. Consequently, the effective federal funds rate was traded on average at 0.375 percent after the Fed hike (a level three times higher than the 0.125 percent in 2015 before the hike). The chart below shows the Fed’s interest rates before and after the December hike. As one can see, the effective rate is actually formed between the ON RRP rate and IOER, which were set during the December meeting at, respectively, the lower and upper bounds of the federal funds target.
Chart 2: The Fed's interest rates (discount rate – red line; green line – IOER; blue line – effective federal funds rate; purple line – ON RPP rate) before and after the December hike (between December 1, 2015 and January 6, 2015).
Therefore, the Fed’s tightening cycle inaugurated in December 2015 would be based on the use of relatively new tools, such as IOER and RRP. As the Fed is entering uncharted waters, the use of these interest rates could alter financial markets in unpredictable ways and further impair the functioning of free markets. Moreover, the Fed could risk losing credibility if it loses control over the federal funds rate in case of some negative shock.
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