Roberto Perotti
Version 2.0
September 13, 2016
3 THE CONDUCT OF MONETARY POLICY
THE FEDERAL FUNDS MARKET
Banks with excess reserves at the Fed can lend these excess reserves to institutions that need
liquidity. The market of banks’ reserves at the Fed is called the federal funds market. Of course, federal
funds transactions neither increase nor decrease total reserves, rather they redistribute reserves.
Federal funds are the heart of the money market: they are the core of the overnight market for
credit in the United States. Moreover, current and expected interest rates on federal funds are the basic
rates to which all other money market rates are anchored.
Federal funds can be borrowed by only those depository institutions that are required by the
Monetary Control Act of 1980 to hold reserves with Federal Reserve Banks. They are commercial banks,
savings banks, savings and loan associations, and credit unions. Depository institutions are also the most
important eligible lenders in the market.
Funds lent in the overnight fed funds market typically must be returned to the lender within 24
hours. Participants can arrange fed funds transactions directly with each other (bilaterally), or through the
brokers. These are unsecured loans. It is important to note that the Federal Reserve Banks are not party
to these transactions.
Two methods of federal funds transfer are commonly used. To execute the first type of transfer,
the lending institution authorizes the district Reserve Bank to debit its reserve account and to credit the
reserve account of the borrowing institution. Fedwire, the Federal Reserve System's wire transfer
network, is employed to complete a transfer.
The second method simply involves reclassifying respondent bank demand deposits at
correspondent banks as federal funds borrowed. Here, the entire transaction takes place on the books of
the correspondent.
The weighted average rate at which these transactions occur is called the federal funds rate.
The federal funds rate is the central interest rate in the U.S. financial market. It influences other
interest rates such as the prime rate, which is the rate banks charge their customers with higher credit
ratings. It also influences other money market interest rates. According to the expectation theory of
interest rates, an interest rate over a certain horizon is determined from the sequence of expected shortterm interest rates over that horizon, plus possibly a risk premium. Intuitively, this is so because the
borrower can borrow at, say, a three-month horizon at the three-month interest rate or she can borrow
at a three month horizon by borrowing daily at the overnight interest rate and rolling over this loan for
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three month. For instance, consider certificates of deposit (CDs), which are generally arranged for a few
months. A bank can raise funds by issuing a CD or by borrowing daily over the term of the CD through
overnight federal funds and, therefore, chooses whichever option it expects to be cheaper. Likewise, a
corporation considering the purchase of a Treasury bill has the option of lending its funds daily over the
term of the bill at the overnight repo rate, which is closely tied to the federal funds rate. It does
whichever it expects will provide the highest return. Such arbitrage keeps the yields of alternative money
market instruments in line.
Hence, expectations about the federal funds rate influence key longer- term interest rates such
as mortgages, loans, and savings, all of which are very important to consumer wealth and confidence.
Hence, market participants’ expectations about the future target federal funds rate are crucial.
It is very important to note that the federal funds rate is a market interest rate determined in
private transactions. The Federal Open Market Committee (FOMC) of the Fed does not set the federal
funds rate; however, it sets a target level or a target band for the federal funds rate, and can achieve this
target pretty closely.
How? The interest rate on federal funds transactions is determined at the intersection of the
demand and supply curves of these federal funds. The Fed can influence the position and shape of these
two curves, and therefore the equilibrium federal funds rate, through four standard tools of monetary
policy: open market operations, the discount rate, interest on excess reserves and reserve requirements.
Note that the demand and supply curves for federal funds capture the demand and supply by
banks in the interbank federal funds market. In particular, the supply of federal funds curve represents
the interest rate at which banks are willing to lend a certain amount of federal funds to other banks, not
the quantity of reserves supplied by the Fed at a given interest rate (although, obviously, there will be a
relation between the two).
FACTORS AFFECTING THE DEMAND FOR RESERVES
Obviously the demand for federal funds by banks is a decreasing function of the federal funds
rate, which is the cost of borrowing federal funds. However, it is not a straight line because of the
presence of the discount window.
The interest rate on the lending facility (the discount rate)
In the lending facility (“discount window” in the Fed system) a central bank supplies any amount a
bank is willing to borrow at a penalty interest rate set by the central bank itself.
In the Fed system, the most important facility of the discount window is the Primary Credit
Facility. This is directed to financially sound institutions with sufficient collateral; hence it is extended
largely without administrative restrictions. Still, it is intended as a backup source of credit, not a regular
source of funding; in fact, we have seen that in normal times, as in July 2016, it had a minimal weight in
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the balance sheet of the Fed. 1 The interest rate on the Primary Credit Facility is called the “discount
rate”, which we denote by id. The discount rate is set above the target federal funds rate in order to
impose a penalty on depository institutions that borrow from the central bank rather than in the
interbank market.
The presence of this facility puts a ceiling on the interest rate a bank is willing to pay when
borrowing for federal funds: obviously no bank in the federal funds market will accept to pay an interest
higher than the discount rate id when it can borrow any amount at that interest rate.
Thus, the demand for federal funds looks like in Figure 1 it is flat at id.
Figure 1: The demand for federal funds
Reserve requirements
Obviously increasing the reserve requirement ratio shifts the demand for reserves to the right:
banks with not enough reserves must borrow reserves to satisfy the reserve requirement from banks with
excess reserves.
1
The Federal Reserve also provides a “secondary credit facility,” through which it lends funds at a higher
rate to less-sound financial institutions. Finally, the Federal Reserve has a “seasonal credit facility” designed to help
small depository institutions manage seasonal fluctuations in their loans and deposits
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How does the reserve requirement work in practice? The reserve requirement is defined over a
period of two weeks (the “maintenance period”), with a lag. “Over each two-week reserve maintenance
period, which begins every other Thursday, each bank is required to hold a quantity of reserves in
proportion to the quantity of transactions deposits on its balance sheet taken from a previous two-week
reserve computation period. This reserve requirement can be satisfied either by holding balances at the
Federal Reserve during the reserve maintenance period, or with cash held on a bank’s premises during
the computation period (called “applied vault cash”). To meet the portion of reserve requirements not
satisfied with vault cash, a bank my accumulate reserves over a maintenance period in any daily pattern,
based on its end-of-day holdings.
A bank is penalized for ending any day overdrawn on its account at the Fed, as well as for failing
to meet its requirements by the end of the maintenance period. To obtain the necessary reserves to avoid
these fees (if unable to borrow the necessary amount of reserves from another bank), a qualifying bank
may borrow reserves directly from the Federal Reserve at its discount window facility under the primary
credit program.” (Hilton pp. 4-5)
FACTORS AFFECTING THE SUPPLY OF FEDERAL FUNDS
The FED can control the supply of reserves quite precisely, through two main tools: open market
operations and the lending facility.
Open Market Operations 2
The most important way the Fed determines the supply of reserves and therefore of federal funds
is by Open Market Operations (OMO). This are of two types: outright purchases or sales in the open
market by the Fed of high quality securities (government securities and agency MBS) held to maturity, and
repurchases agreements. Repurchase agreements are a form of collateralized loan where the Fed lends
money to primary dealers, and the primary dealers give the Fed high-quality securities as general
collateral against the loan. At expiration (which can go from one day to several months) the dealer
repurchases the security. The difference between the price of the first transaction and the (higher) price
of the second transaction gives, implicitly, the interest rate paid by the dealer (the borrower). In this
process, reserves are expanded temporarily, for the duration of the repo. In a reverse repurchase
agreement the Fed borrows money from primary dealers, and gives them high-quality securities as
general collateral against the loan. In this process, reserves are contracted temporarily.
Long-term repos used in open market operations have a maturity of 14-days and are conducted
early every Thursday morning. The long-term repo book is used to offset seasonal movements in factors.
The short-term repo book consists of repos with shorter-than-14-day maturities, and is dominated by
This is largely based on https://www.newyorkfed.org/aboutthefed/fedpoint/fed15.html and
https://www.newyorkfed.org/aboutthefed/fedpoint/fed32.html
2
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overnight repos. These operations are typically conducted every day to fine-tune the level of banking
reserves needed on that day.
To implement open market operations, the FOMC delegates responsibility to the Manager of the
System Open Market Account (SOMA) at the Federal Reserve Bank of New York. The SOMA Manager is
responsible for the staff of the Trading Desk at the Federal Reserve Bank of New York (“the Desk”). The
Desk thus executes open market operations on behalf of the entire Federal Reserve System.
After each policy meeting, which occur every six to eight weeks, the FOMC issues a Directive to
the SOMA Manager outlining the approach to monetary policy that the FOMC considers appropriate for
the time period between its meetings. The Directive contains the rate at which the FOMC would like fed
funds to trade over the intermeeting period.
The NY Fed Trading Desk conducts open market operations with primary dealers—government
securities dealers who have an established trading relationship with the Federal Reserve. Primary dealers
serve as trading counterparties of the New York Fed in its implementation of monetary policy. This role
includes the obligations to: (i) participate consistently in open market operations; and (ii) provide the New
York Fed's trading desk with market information and analysis helpful in the formulation and
implementation of monetary policy. Primary dealers are also required to participate in all auctions of U.S.
government debt and to make reasonable markets for the New York Fed when it transacts on behalf of its
foreign official account-holders. Currently, these are the primary dealers:
Bank of Nova Scotia, New York Agency
BMO Capital Markets Corp.
BNP Paribas Securities Corp.
Barclays Capital Inc.
Cantor Fitzgerald & Co.
Citigroup Global Markets Inc.
Credit Suisse Securities (USA) LLC
Daiwa Capital Markets America Inc.
Deutsche Bank Securities Inc.
Goldman, Sachs & Co.
HSBC Securities (USA) Inc.
Jefferies LLC
J.P. Morgan Securities LLC
Merrill Lynch, Pierce, Fenner & Smith Incorporated
Mizuho Securities USA Inc.
Morgan Stanley & Co. LLC
Nomura Securities International, Inc.
RBC Capital Markets, LLC
RBS Securities Inc.
Societe Generale, New York Branch
TD Securities (USA) LLC
UBS Securities LLC.
Wells Fargo Securities, LLC
5
(For a list updated in real time, see here; for detailed information on all OMOs conducetd by the FE, see
here)
This structure works because the primary dealers have accounts at clearing banks, which are
depository institutions with accounts at the Fed. So when the Fed sends funds to and receives funds from
the dealer's account at the latter’s clearing bank, this action adds or drains reserves to the banking
system.
Lending facility
The discount window affects not only the demand for federal funds but also the supply. Once the
FED has set the discount rate, eligible banks can borrow at will at that rate. If the FFR were above id ,
banks would have an incentive to borrow infinite amounts at id and lend at FFR, pocketing the difference
without risk. Hence the supply of federal funds is infinitely elastic at id. The supply of federal funds is
pictured in Figure 2.
Figure 2: The supply of federal funds
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Autonomous factors
Through OMOs, the Fed can control the supply of federal funds quite closely. However, there are
two factors affecting the supply of federal funds that are beyond the FED’s control. The first and most
important is the demand for currency. As we have seen, an increase in the demand for currency by the
public reduces excess reserves and therefore the supply of federal funds. When the demand for currency
by the customers of a bank increases, the Fed provides currency to the bank and in exchange it debits the
reserve accounts of that bank in payment for the currency that it ships to that bank. Hence, an increase in
the demand for currency reduces the supply of federal funds and shifts the supply curve to the left. 3
Note that an increase in currency demand is equivalent to an increase in the currency / deposit
ratio c: as we have seen, this does not change the monetary base, but exactly for this reason it does
reduce the supply of excess reserves.
OPERATING PROCEDURES BEFORE THE CRISIS: ACHIEVING THE TARGET FEDERAL
FUNDS RATE
In the pre-crisis environment of reserve scarcity, the operating regime was based on managing
the supply of reserves. The Desk’s job was to design and execute open market operations to adjust the
supply of reserves in the banking system to a level that would intersect the demand for reserves at the
FOMC’s target rate. This framework relied on a structural deficiency, meaning that the Desk created
permanent additions to the supply of reserves (through outright purchases of Treasury securities) that
were somewhat lower than the total need.
Then, on a seasonal and daily basis, the Desk was in a position to add (or occasionally drain)
reserve balances temporarily to get to the desired level through fine-tuning repo (or reverse repo)
operations with primary dealers. Each workday, Desk staff had to gather information to assess near-term
conditions in the repo and federal funds markets, as well as banks’ reserve needs and plans for meeting
them.
Reserve forecasters at the New York Fed and Board of Governors compiled data on bank reserves
for the previous day and made projections of factors that could affect the demand for federal funds and
that part of the supply of federal funds that is due to autonomous factors, i.e. to factors beyond the Fed’s
control, in particular the demand for currency, the Treasury’s account balance, and accounts held by
foreign official institutions at the New York Fed. Using this collection of information, staff developed plans
for the day’s operation(s), outlining the quantity of reserves to add or drain and the term of the
operation(s). This plan was reviewed by staff at the Board of Governors before the Desk executed it in the
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Fed.
The second most important autonomous factors is payments into and out of the Treasury account at the
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open market, and the FOMC ratified the Desk’s transactions over each intermeeting period at the
Committee’s subsequent meeting.
The equilibrium FFR is determined by the crossing of the demand and supply curves for federal
funds, as in Figure 3
Figure 3: The equilibrium FFR
In the five years prior to the crisis, this system functioned with an average of $20 billion in reserve
balances and about $1.5 billion in excess reserves. Under this framework of announcing the target level
and making small changes in the aggregate supply of reserves, the Federal Reserve was able to reliably
affect the market-determined level of the federal funds rate and keep it close to the FOMC’s target.
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OPERATING PROCEDURES DURING AND AFTER THE CRISIS
3.5.1
Operating procedures during normalization
Between 2008 and the end of 2015, several rounds of large-scale asset purchase programs raised
the level of Federal Reserve liabili-ties in excess of Federal Reserve notes to $3.07 trillion (mostly in the
form of reserves), a level at which small variations in the supply of reserves would be unlikely to cause
meaningful changes in the level of rates in the federal funds market, as they did before the crisis.
In an environment of abundant reserves, implementation of monetary policy would therefore
require a new operational approach to influence short-term interest rates when the FOMC determined
the time had come to start raising them. The FOMC developed a framework for maintaining interest rate
control, based on a system of rates administered directly by the central bank to influence the level of
short-term market rates.
The FOMC outlined its anticipated approach to removing monetary policy accommodation in a
statement of Policy Normalization Principles and Plans, published in September 2014. In its statement, the
Committee noted its plans to reduce monetary policy accommodation by raising its target range for the
federal funds rate. It said that the Federal Reserve intended to move the federal funds rate into the target
range primarily by adjusting the interest rate it paid on excess reserve balances (IOER), and would use an
overnight reverse repurchase agreement (ON RRP) facility and other supplementary tools, as needed, to
help control the federal funds rate.
In its March 2015 meeting minutes, the FOMC provided additional details about its intended
operational approach at the commencement of policy firming. The Federal Reserve affirmed that it
intended to target a range for the federal funds rate between 0 and 25 basis points, and to set the IOER
rate and the offering rate associated with an ON RRP facility equal to the top and bottom of the target
range, respectively.
On December 16 2015, citing considerable improvement in labor market conditions and
reasonable confidence that inflation would rise over the medium term to its 2 percent objective, the
FOMC lifted its federal funds target from the 0 to ¼ percent range that had been in effect since December
2008. The FOMC commenced policy firming (a process that some refer to as liftoff) by raising its target for
the federal funds rate to a range of ¼ to ½ percent and by rolling out the policy implementation
framework described in the preceding section of this report.
Specifically, the Board of Governors raised the interest rate paid on required and excess reserves
to 0.50 percent. Additionally, effective December 17, the FOMC directed the Desk to undertake ON RRP
operations at an offering rate of 0.25 percent and term RRP operations spanning the year-end to maintain
the federal funds rate in the new target range (see Figure 4).
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Figure 4: The target and effective FFR
Source: Domestic open market operations during 2015, published by the Board of Governors of the FED.
Thus, after seven years of using changes in the size and composition of its balance sheet (and
forward guidance on short-term interest rates) to provide monetary policy accommodation while the
FOMC’s target for the federal funds rate was near zero, the FOMC’s normalization framework now
focuses once again on tools for managing short-term interest rates as the main mechanism for
implementing monetary policy.
Unlike the pre-crisis framework of reserves management, however, the normalization framework
relies on an IOER rate and (at least temporarily) on an ON RRP offering rate as administered rates directed
by the central bank as the means for moving the federal funds rate into the FOMC’s target range, without
necessarily draining reserves.
3.5.2
Two additional tools: the IOER as a floor to the FFR, and the reverse repurchases.
Interest on reserves 4
Paying interest on reserves at the FED is a rather recent phenomenon, dating to 2008. Before the
crisis, Congress passed the Financial Services Regulatory Relief Act of 2006 authorizing the Federal
Reserve to begin paying interest on reserves. The legislation was supposed to go into effect beginning
4
This is taken largely from http://www.frbsf.org/education/publications/doctor-econ/2013/march/federalreserve-interest-balances-reserves/
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October 1, 2011. However, during the financial crisis, the effective date was moved up by three years
through the Emergency Economic Stabilization Act of 2008. 5
Why did the Fed begin to pay interest on excess reserves? Paying interest on reserves (which we
denote by ir) sets a floor on the FFR: if the FFR is below ir, a bank can borrow at the FFR and deposit what
it borrows as excess reserves at the Fed, earning the difference between ir and the FFR without any risk.
Hence, as long as FFR < ir there would be an infinite demand for federal funds: the demand for federal
funds is infinitely elastic at ir (see Figure 5).
Figure 5: The demand for federal funds with an interest rate on reserves
Similarly, the supply of federal funds is also infinitely elastic at ir. If the Fed pays interest on
reserves, the supply curve for federal funds cannot go below ir , if the FFR is below ir banks would prefer
to “lend” to the Fed by increasing their excess reserves at the Fed rather than lending at the FFR. Thus,
the supply curve for federal funds is also flat at ir as in Figure 6
5
Globally, a number of central banks have the authority to pay interest on reserves held against deposits.
For example, the Bank of England has paid interest on reserves since 2009, and the European Central Bank has had
this authority from its inception in 1999.
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Figure 6: The supply for federal funds with an interest rate on reserves
.
But why did the Fed need a floor to the FFR? The reason was the enormous increase in liquidity
created by the Fed during the crisis. With only two exceptions (September 2001 following the terrorist
attacks and August 2007 at the onset of the global financial crisis), excess reserves were less than 10% of
total reserve holdings, because depository institutions had an incentive to minimize noninterest-bearing
excess reserves held at the Fed. For instance, in 2007 required reserves averaged $43 billion, while excess
reserves averaged only $1.9 billion. In the first six months of 2012 required reserves averaged almost
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$100 billion, while excess reserves averaged $1.5 trillion. The dramatic change in the evolution of excess
and required reserves is depicted clearly in see Figure 7.
Figure 7: Required and excess reserves
Federal Reserve Bank of St. Louis, Excess Reserves of Depository Institutions [EXCSRESNS], retrieved from FRED, Federal
Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/EXCSRESNS , July 25, 2016.
Board of Governors of the Federal Reserve System (US), Required Reserves of Depository Institutions [REQRESNS],
retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/REQRESNS, July 25, 2016.
As we have seen, since January 2009, the monthly average interest rate on both required reserve
and excess reserve balances has been 25 basis points, or 0.25% at an annual rate, while the federal funds
target range was 0 to 25 basis points. When the FFR target range was increased to 25 to 50 basis points in
December 2015, the interest rate on reserves was increased to 50 basis points (see here for current
information on the interest on reserves).
In theory, the IOER rate is meant to act as a floor beneath overnight interest rates. In practice,
however, rates in U.S. money markets have fallen below the IOER rate. In fact, since end 2008, when the
Fed started paying interest on reserves, the federal funds rate has persistently traded below the rate paid
on reserves. As a result, interest on reserves has proven to be a soft floor in the United States
Why any financial institution would make a risky loan in the federal funds market to another
institution at a rate below the risk-free rate paid by the Federal Reserve is puzzling. The answer to the
puzzle is likely found in the institutional characteristics of the federal funds market. In particular, the soft
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floor is likely due to the presence of financial institutions in the overnight market that, under current law,
are not eligible to receive interest on reserves held at the Federal Reserve. In particular, the governmentsponsored enterprises (GSEs)—including Fannie Mae and Freddie Mac—and some international
institutions have accounts at the Reserve Banks but receive no interest on the reserves held in those
accounts. As a result, these institutions have an incentive to lend overnight funds to other institutions
willing to pay a positive rate of return.
However, normally banks might be expected to be willing to pay up to the interest rate on
reserves to borrow from the GSEs. A bank could borrow from the GSE at a rate below what it receives
from the Federal Reserve and deposit the funds at the Fed. In this transaction, the bank would earn a
return equal to the difference between the rate of interest on reserves and the rate paid to borrow from
the GSE. As banks competed to borrow from the GSEs, the overnight rate paid to the GSEs might be
expected to rise up to the level of the interest rate on reserves. However, this arbitrage opportunity has
not been fully exploited, and the funds rate has tended to trade below the floor established by the
interest rate on reserves.
Among a number of explanations offered for this anomalous behavior, the most common view is
that the GSEs have limited their lending to a small number of banks. They have done this because their
overnight loans are not collateralized and therefore carry some risk of default. Especially in the current
situation, where many banks have failed, the risk of default has apparently made the GSEs cautious about
which banks to lend to and how much they lend. While the risk to the GSEs is likely small, it has allowed
the banks to exert some market power over the GSEs which in turn has allowed the banks to pay a lower
rate on overnight funds than the rate on reserves.”
The standing reverse repurchase facility
To overcome the problem of the soft floor provided by the IOER, a standing ON RRP facility—
through which the Federal Reserve offers a risk-free overnight asset with same-day settlement to a broad
range of money market participants, at a rate managed by the Federal Reserve — has been set up to
support policy implementation during normalization by helping to firm the floor beneath money market
rates. In fact, as we have seen, the Fed set the IOER rate and the offering rate associated with an ON RRP
facility equal to the top and bottom of the target range of 0,25 to 0,50 percent, respectively.
Importantly, the Desk offered reverse repos to a broad set of money market participants,
including primary dealers and an expanded set of counterparties that included money market funds,
government-sponsored enterprises, and banks . Currently, there are 142 counterparties for RRPs.
Making such assets available widens the universe of counterparties that should be unwilling to
lend at rates below those available from the Federal Reserve, thereby strengthening the bargaining
position of nonbank lenders and enhancing competition in markets. In this way, an ON RRP facility can
complement the upward pull of IOER as the FOMC raises its target range for the federal funds rate. Figure
8 shows the amount of reverse repos outstanding since 2014.
Figure 9 shows the relation between the FFR, the IOER and the interest on reverse repos. It is
evident that the FFR was always below the IOER.
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Figure 8: Outstanding reverse repos
Source: Domestic open market operations during 2015
Figure 9: The FFR, the IOER, and the RRP interest rate
Source: Domestic open market operations during 2015
The next figure shows clearly that the majority of RRP has been conducted with counterparties
other than the primary dealers:
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Figure 10: Counterparties in reverse repos
Source: Domestic open market operations during 2015
3.5.3
The corridor and floor systems
With an IOER and a RRP facility, the FFR must necessarily move within two bounds, the interest
on reserves at the bottom and the discount rate at the top. This range is typically called “the corridor”. 6 In
theory, a corridor system could limit volatility in the policy rate and isolate interest rate policy from the
size of the balance sheet. Regardless of the supply of reserves, the central bank can tightly control the
interest rate on overnight funds (in reality, the Fed s operating in a “floor” system, because as we have
seen the upper bound of the range, represented by the discount rate, is not relevant in the current
environment of large liquidity.)
When the central bank increases the supply of reserves, the supply schedule shifts to the right, as
illustrated in Figure 10 by the shift in the supply curve from R1s to R2s. In the traditional framework (not
shown in the figure), such an increase in reserves would cause the policy rate to decline along a
continuously downward-sloping demand curve. As the supply was steadily increased, the policy rate
would eventually fall to the zero lower bound. In the corridor system, however, the decline in the policy
rate is limited by the floor of the corridor—the interest rate on excess reserves.
While the Federal Reserve is currently relying on the interest rate on reserves to help keep the federal
funds rate above its zero lower limit, the Fed has not formally adopted a corridor system. In contrast, a number of
central banks—including the Bank of Canada, Bank of England, Bank of Japan, European Central Bank (ECB), Norges
Bank, Reserve Bank of Australia, Reserve Bank of New Zealand, and the Swedish Riksbank—have for some time
operated under various versions of the corridor system. In the recent financial crisis, however, the ECB, Bank of
Japan, Bank of England, Bank of Canada, and the Norges Bank have all moved to a floor system. The other central
banks have maintained their policy rates near the center of their respective corridors.
6
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Figure 11: Effects of an increase n reserves with a floor to the FFR
More importantly, the floor established by the interest rate on reserves will, in theory, also help
the Federal Reserve in the normalization phase, in exiting the current highly accommodative policy stance
without causing too much disruption in the money market. The Federal Reserve can raise the overnight
interbank rate by announcing an increase in the interest rate on reserves. This action can be implemented
without a reduction in the supply of reserves, allowing the Fed to independently determine the
appropriate speed with which to shrink its balance sheet (see Figure 11). Combined with various tools to
shrink the balance sheet, the payment of interest on reserves will allow the Federal Reserve to eventually
renormalize monetary policy.
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Figure 12: Effects of an increase in the interest on reserves
3.5.4
Operating procedures during normalization
Thus, in the current environment of reserve abundance, the operating regime is based on
administered overnight rates, which, by encouraging market competition for short-term funds, help to
guide rates up into the FOMC’s target range. The payment of interest on reserves (IOER) is the primary
tool, and reverse repo operations (ON RRP) conducted by the Desk play a supplementary role.
In addition, the design of the reverse repo operations differs from that before the crisis. Unlike
the quantity-based temporary operations the Desk previously used to fine-tune the supply of reserves,
the Desk now offers reverse repos through a temporary facility at a pre-established rate set by the FOMC.
The staff’s primary analytical role has changed from reserve forecasting to monitoring and
analyzing medium-term trends and relationships in a range of money markets, with the goal of assessing
market participants’ behavior, measuring the impact of the Federal Reserve’s operations on market
structure, calibrating the Federal Reserve’s implementation tools, and analyzing policy transmission
across money markets broadly.
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REFERENCES
A very useful reference is Domestic open market operations during 2015, published by the Board
of Governors of the FED. It describes the operating procedures before and after the financial crisis, and
numerous other aspects.
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