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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

Tracking more Fed policy tools

Those outside the Fed often cite the federal funds rate as the only tool in the FOMC’s monetary policy toolbox. But there are more—a fact first demonstrated when the FOMC employed “non-traditional” policy instruments in its successive quantitative easing programs, all of which involved purchasing some assets. As the FOMC has started to increase the federal funds rate target from near zero, it has also made clear that it can also use two other interest rates to set monetary policy: the interest rate on required reserves and the interest rate on excess reserves. FRED has recently added data on these two rates so users can track how these policy instruments are evolving.

The graph above shows these three rates: the federal funds rate target, which has an upper and lower limit to its range, and the two rates on reserves. At this point, there’s not much to see, as the rates on reserves currently coincide with the lower limit of the federal funds rate target and have done so for some time. But these rates need not follow the same path. In fact, the FOMC may implement policy by adjusting one or more of these rates if necessary.

How this graph was created: Search one by one for the four series and add them to the graph. For a shortcut, search for the series IDs: IORR, IOER, DFEDTARU, DFEDTARL.

Suggested by Christian Zimmermann

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


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