In my last article, we looked at the Federal Funds Rate set by the Federal Open Market Committee. In that article, I discussed how the FOMC adjusted the federal fund rate to their target rate by adjusting the supply of currency in the reserve system. Upon further review, I have found that this was the primary method of changing the fund’s rate before the financial crisis of 2008. This method is still in use but today the Fed requires the banks to keep so great a reserve that to cause a noticeable change through increasing the reserve would require ludicrous amounts of cash to be reserved. In this article, we will review the old method of influencing the rate and the new tools the Fed has moved to.
The image below courtesy of the Federal reserve bank of St. Louis shows how an increase in the supply of currency impacts the discount rate and shifts the FFR lower. As mentioned before the main method of changing supply is for the Fed to buy and sell government-backed securities.
This was the primary method of changing the market rates for the FOMC before the financial crisis from 2007-2009. To keep the target rate low during and after the crisis the FOMC kept increasing the reserves. By 2015 the reserve was 180 times the size of the 2007 reserve. This means on the chart the supply line has shifted so far to the right that any further change in supply can’t make a meaningful difference in demand without requiring a massive movement of funds.
The FOMC has begun to use 2 new tools to influence the Federal Funds Rate now that adjustments to the reserve supply is ineffective. The first is the Interest on Reserves or IOR. This rate is the amount the Fed pays for funds stored in the reserve accounts by banking institutions. It is lower than the Federal Funds Rate but has extremely low risk. This creates a floor for the FFR as if the market rate drops below the IOR then the banks will store their funds at the federal reserve rather than deal with each other. The second tool is the ON RRP or Overnight Reverse Repurchase Program. This program allows financial institutions to buy security from the Fed for the night with the Fed rebuying the security in the morning. This rate is lower than the IOR but offers a market rate floor for institutions that can not take advantage of the Interest on Reserve system. Again the Federal Reserve Bank of St. Louis has a good animation of how these rates interact with the FFR.
Acquisition & Financial AnalystMarcus Baker
email: [email protected]