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FOMC Minutes Discuss Rate Rises

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The Pound briefly spiked higher on Wednesday as the MPC’s Bank Rate Votes showed that two members had voted to increase rates – a break from expectations and several years of interest rate stability in the UK. The last dissenting votes occurred in 2011, and rates have been unchanged since 2009 at 0.50%.

While the Pound did spike 75 pips higher on the news, consistent downward pressure saw the gains erased and the currency reach new lows of 1.6565 for the week.

The FOMC minutes revealed further discussion of the eventual exit strategy for its extraordinary stimulus program and zero interest rates: “Participants agreed that adjustments in the IOER rate would be the primary tool used to move the federal funds rate into its target range and influence other money market rates. In addition, most thought that temporary use of a limited-scale ON RRP facility would help set a firmer floor under money market interest rates during normalization.”

As a reminder, the reason for the need to use three policy tools to raise interest rates is due to the current level of excess reserves in the banking system. Fed purchases of financial assets generate reserve account balances in participating banks. Because there is no reserve requirement attached to these reserve balances, they are excess reserves.

The Fed must pay interest on these reserves to keep a floor under interest rates. Because the reserves are not needed by the banks, absent interest on reserves (IOR), the excess reserves would be lent in the interbank market, putting downward pressure on the interbank rate. This occurs because banks would rather lend the funds at any rate, rather than receiving nothing in interest from the Fed.

By paying IOR, the Fed places a floor under interbank lending rates and prevents losing control over this policy tool when it finally moves to raise the Fed Funds Rate. The Reverse Repurchase Facility expands the list of counterparties to include those such as money-market funds and government sponsored entities (GSE’s) such as Freddie Mac and Fannie Mae. These parties previously could not receive interest on reserves. This will lead to a combination of the three policy tools to normalize interest rates, and the FOMC will continue discussing these factors through to the first rate rise.

In other news, China HSBC Flash Manufacturing PMI was announced yesterday. The PMI figure showed that Chinese manufacturing expanded, but at a slower than expected pace. The figure of 50.3 was well below expectations of 51.5, and the AUD sold off following the announcement before finishing the day higher.

European PMI’s were mixed, largely indicating expansion in the services sector. The Euro was largely unaffected by the data.

Tonight sees important speeches by central bank heads Mario Draghi and Janet Yellen at the Jackson Hole Symposium. Economists and analysts are unsure of whether the meeting will be used to strike a dovish or a hawkish tone, and whether any new policy direction will be announced.

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