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Posts tagged with: "IOER"

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Visualizing the Fed’s new monetary policy tools

First, let’s introduce some of the monetary policy terms we’ll be using here:

  • Federal Open Market Committee (FOMC): The seven members of the Board of Governors; the president of the Federal Reserve Bank of New York; and, on a rotating basis, the presidents of four other Reserve Banks. Nonvoting Reserve Bank presidents also participate in deliberations and discussion.
  • Federal funds rate (FFR): The interest rate at which depository institutions and Federal Home Loan Banks borrow and lend reserve balances to each other overnight.
  • Interest on reserve balances (IORB): Interest paid on reserves that banks hold in their accounts at a Federal Reserve Bank.
  • Overnight reverse repurchase agreement (ON RRP): An overnight transaction in which the Federal Reserve sells a security to an eligible counterparty and simultaneously agrees to buy the security back the next day.

The FOMC sets the stance of monetary policy by adjusting the target range for the FFR. To ensure the target range is transmitted to market interest rates, the FOMC uses the IORB as the primary tool and the ON RRP facility as the supplemental tool. The graph above shows that the Fed has successfully transmitted its desired policy stance to financial markets: The effective FFR has been within the upper and lower limits of the target range set by the FOMC—that is, the blue line stayed between the red and green lines.

Let’s look at these two “administered” rates* that the FOMC has used to steer the FFR within the target range:

  1. Banks earn interest on reserve balances (IORB) on the funds they place in their reserve accounts at the Fed. Because the IORB rate serves as a reservation rate for banks, and banks can arbitrage the difference between IORB and other short-term rates, it is an effective tool for guiding the FFR.**
  2. The Fed offers a broad set of large financial institutions the opportunity to deposit funds at the Fed overnight (with a security held as collateral) in the overnight reverse repurchase agreement (ON RRP) facility. Many of these financial institutions do not have access to interest on reserves. The Fed announces the capacity of the facility and an offering rate. Institutions then place bids that include the amount of their deposit and the minimum interest rate they would receive from the Fed. As long as the total amount of funds that institutions bid is less than the Fed’s set capacity, institutions’ full bid amounts are placed in the facility and the funds earn the ON RRP offering rate. However, if there is more demand than capacity, the Fed sorts the bids by their rates, lowest to highest, and awards funds to institutions in that order. The bid rate for the last institution to be accepted into the facility (once capacity is reached) becomes the award rate for all institutions. The Fed has set a large capacity, though, and the ON RRP offering rate has been the award rate in all auctions to date. As with the IORB rate, institutions use the ON RRP offering rate to help them arbitrage other short-term rates. Because it is set below the IORB rate, it serves as a supplementary rate and acts like a floor for the FFR.

The graph above shows the Fed’s new implementation tools in action. After the Great Financial Crisis, the Fed held the target range for the FFR at 0 to 25 basis points until December 16, 2015 (a date known as “liftoff”). Since then, the FOMC has adjusted the target range up and down several times, including a recent return to the range of 0 to 25 basis points on March 15, 2020, in response to the economic effects of the COVID-19 pandemic. When the FOMC moved the target range, the administered rates were also adjusted, and the FFR (green line) moved simultaneously.

The Fed determined the appropriate IORB rate (red line) and ON RRP offering (and, hence, award) rate (blue line) to keep the FFR in the target range. Over time, the administered rates have been adjusted relative to the range and relative to each other over time. The settings of the Fed’s administered rates are always determined to keep the FFR within the target range. For example, at liftoff, the IORB rate was set at the top of the range and the ON RRP offering (award) rate at the bottom of the range. But, over time, as market pressures moved the FFR toward the top of the target range, the Fed moved the IORB rate a bit lower and within the target range. This is visible in the next graph: Before June 16, 2018, the IROB rate (labeled as “interest rate on excess reserves”) is not visible because it lies beneath the upper limit of the federal funds target range. As the Fed lowered the IORB rate to move the FFR toward the middle of the target range, the IORB rate becomes visible and the FFR moves down in the range. The Fed has made two similar adjustments,  moving the IORB rate lower relative to the upper limit of the target range. The ON RRP offering rate, acting as a floor, has remained at the bottom of the range over most of this period, with the award rate being a touch below the lower limit a few times.

The Fed’s toolbox includes two other tools that support effective policy implementation. The discount rate acts a ceiling for the FFR because banks should not be willing to pay more for funds than the rate at which they can borrow from Fed. And, the Fed conducts open market operations – while no longer the primary tool for adjusting the FFR, the Fed uses open market operations periodically to ensure that the reserves in the banking system remain ample.

For more information, see The Fed’s New Monetary Policy Tools.

*An “administered” rate is an interest rate set by a central authority, such as the Fed, as opposed to an interest rate determined in a market.

**These data are listed in FRED as “interest rate on excess reserves.” Since the Fed decided to reduce reserve requirements to zero percent, it has indicated it may change the name to better reflect current use of the tool.

How this graph was created: First graph: Search for and select “Federal Funds Target Range – Upper Limit,” “Federal Funds Rate – Lower Limit,” and “Effective Federal Funds Rate (daily)” and click “Add to Graph.” From the “Edit Graph” panel, use the “Add Line” option to search for “Interest Rate on Excess Reserves” and then select “Add data series.” Adjust the date range to January 1, 2015, to the current date. Second graph: Search for and select “Overnight Reverse Repurchase Agreements Award Rate: Treasury Securities Sold by the Federal Reserve in the Temporary Open Market Operations,” “Interest Rate on Excess Reserves,” and “Effective Federal Funds Rate (daily).” Adjust the date range to January 1, 2015, to the current date. Third graph: Start with the second graph, search for and select “Federal Funds Target Range – Upper Limit,” and “Federal Funds Rate – Lower Limit” and “Effective Federal Funds Rate (daily).” Adjust the date range to January 1, 2018, to June 30, 2020. In all cases, adjust the colors to your liking with the color palette in the “Edit Graph” panel’s “Format” tab.

Suggested by Scott Wolla and Jane Ihrig.

View on FRED, series used in this post: DFEDTARL, DFEDTARU, DFF, IOER, RRPONTSYAWARD

Fixing the “Textbook Lag” with FRED (Part II)

Monetary policy in a world of ample reserves

Your economics textbook may still say the Federal Reserve uses open market operations to influence the federal funds rate. But in today’s economy, the Fed uses different policy tools.

In simple terms, this is how monetary policy currently works: The FOMC sets a target range for the federal funds rate (FFR) and uses interest on excess reserves (IOER) and the overnight reverse repurchase agreement (ON RRP) facility to keep the FFR rate in the target range. (See our previous post for an introduction to this topic.)

The Fed pays IOER to banks holding reserves at the Fed, which offers those banks a safe, risk-free investment option. Arbitrage ensures that the FFR doesn’t drift too far from the IOER rate. If the FFR drifts much below the IOER rate, banks then have an incentive to borrow in the federal funds market at the lower FFR and deposit those reserves at the Fed to earn the higher IOER rate.

From December 16, 2008, to June 13, 2018, the IOER and ON RRP rates, respectively, served as the upper and lower limits of the FFR target range. The FFR moved between the two rates, but over time it has moved closer to the IOER—that is, the gap between the two has closed, as shown in the FRED graph above.

Again, because the IOER rate was set at the upper limit of the target range, as the FFR moved closer to the IOER rate, by definition it moved closer to the upper limit of the range. To ensure that the FFR remained within the range, the Fed has lowered the IOER rate by 5 basis points at three different times in the past year: June 13, 2018; December 19, 2018; and May 1, 2019. The IOER is now set 15 basis points below the upper limit of the target range.

These changes weren’t changes in monetary policy (which affects the choice of target range), but rather were slight adjustments to where the FFR sits within the range. Chairman Jerome Powell explained that the adjustments were intended to “move the federal funds rate closer to the middle of the target range” in his press conference on June 13, 2018. The changes can be seen on the FRED graph below: Prior to the June 13, 2018, adjustment, the upper limit of the FFR target range and the IOER rate were indistinguishable because IOER rate was set at the upper limit of the target range. After June 13, 2018, the IOER rate (green line) is below the upper limit of the FFR target range (red line).

These changes have ensured that the FFR has remained between the upper and lower limits of the range throughout the period, as illustrated by the FRED graph below.

How these graphs were created: For the first graph: Search for “interest rate on excess reserves,” select “Effective Federal Funds Rate (daily)” and “Interest Rate on Excess Reserves,” and then click “Add to Graph.” Adjust the dates to reflect the indicated range: from December 16, 2008, to the current date. For the second graph: Search for “federal funds rate target” and select “Federal Funds Target Range – Upper Limit,” “Federal Funds Rate – Lower Limit,” and “Effective Federal Funds Rate (daily),” and then click “Add to Graph.” From the “Edit Graph” panel, use the “Add Line” option to search for “Interest Rate on Excess Reserves” and then select “Add data series.” Adjust the dates to reflect the indicated range: from January 1, 2018, to the current date. For the third graph: Search for “federal funds rate target” and select “Federal Funds Target Range – Upper Limit,” “Federal Funds Rate – Lower Limit,” and “Effective Federal Funds Rate (daily),” and then click “Add to Graph.” Adjust to date to show the entire period: from December 16, 2008, to the current date. In each case, you can adjust the colors to your liking by using the color palette in the “Edit Graph” panel’s “Format” tab.

For more information on this topic, see “A New Frontier: Monetary Policy with Ample Reserves.”

Suggested by Scott Wolla.

View on FRED, series used in this post: DFEDTARL, DFEDTARU, DFF, IOER

Paying interest on excess reserves

An additional policy tool for the Fed

Commercial banks must adhere to regulations, including so-called reserve requirements. That is, banks must hold a certain fraction of their deposits as cash in a Federal Reserve account; these are known as “required reserves.” Banks can choose to hold even more cash in those accounts than what the Federal Reserve requires; these are known as “excess reserves.”

The graph above shows that required reserves are quite stable and grow as a constant fraction of total deposits in the banking system. But excess reserves increased considerably in 2008, as the Fed expanded the money supply to finance unconventional monetary policy measures such as quantitative easing. As of May 2018, excess reserves are nearly $1.9 trillion, ten times more than required reserves.

In normal times, excess reserves aren’t profitable, as they don’t earn a return. Instead of holding cash as excess reserves, banks could lend those funds and earn interest. However, after the 2008 recession, the Federal Reserve started paying interest on excess reserves (IOER). By altering the incentives for commercial banks to extend loans or hold excess reserves, the Fed is able to use the IOER as an additional monetary policy tool.

The second graph plots the IOER along with the (effective) federal funds rate, the Fed’s main tool for conventional monetary policy. The federal funds rate can be thought of as the interest rate at which financial institutions make short-term loans to each other. Here, we see that the federal funds rate tracks the IOER very closely. When banks have excess liquidity or reserves, they can choose whether to lend those reserves to other banks (at the federal funds rate) or deposit them at the Fed (and earn the IOER). Banks aren’t willing to lend to each other if the federal funds rate is substantially lower than the IOER, and so the two rates move closely together.

How these graphs were created: For the first graph, search for and select “required reserves of depository institutions” and click “Add to Graph.” From the “Edit Graph” panel, choose “Add Line,” search for and select the monthly “excess reserves of depository institutions” series, and click “Add data series.” The first series is in billions of dollars; to change it to match the second series (in millions of dollars), select “Edit Lines”/”Edit Line 1” and add the formula a*1000. For the second graph, search for and select the monthly “effective federal funds rate” series. From the “Edit Graph” panel, choose “Add Line” and search for and select “interest rate on excess reserves.” Use the date range tool to set the start date in August 2008.

Suggested by Asha Bharadwaj and Miguel Faria-e-Castro.

View on FRED, series used in this post: EXCSRESNW, FEDFUNDS, IOER, REQRESNS


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