When the Federal Reserve conducts monetary policy, it announces a target for the "federal funds" interest rate.
The implication is that if this specific rate rises or falls, it will affect other interest rates throughout the US economy; for example, like federal funds interest rate moves closely together with other key benchmark interest rates, like the interest rate for overnight borrowing on AA-rated commercial paper. However, the identity of the parties borrowing and lending in the "federal funds" market has changed dramatically since the Great Recession. John P. McGowan and Ed Nosal describe the shifts in "How Did the Fed Funds Market Change When Excess Reserves Were Abundant?" (Economic Policy Review, Federal Reserve Bank of New York, forthcoming).
As part of federal financial regulation, banks and certain other financial entities (to which we will return in a moment!) are required to hold a minimum amount of reserves at the Federal Reserve. Back before 2007, banks usually tried to minimize these reserves, because the Fed didn't pay them any interest for the funds in these reserve accounts. But sometimes it would happen, at the end of a business day, that a bank would realize that its deposits and withdrawals has created a situation where it didn't meet the minimum level of reserves. For a fundamentally healthy bank, this wasn't a problem. The bank with a slight deficiency of reserves would borrow from another bank that had ended the day with a slight excess of reserves. The "federal funds" interest rate was the rate paid for this lending, which was typically for a very short-term loan, like overnight. As McGowan and Nosal write:
Prior to the 2007 financial crisis, trading in the fed funds market was dominated by banks.1 Banks managed the balances—or reserves—of their Federal Reserve accounts by buying these balances from, or selling them to, each other. These exchanges between holders of reserve balances at the Fed are known as fed funds transactions.
But during the Great Recession and its aftermath, the Fed used large-scale asset purchases, sometimes known as "quantitative easing," to conduct monetary policy. The Fed purchased several trillion dollars in US Treasury bonds and in mortgage-backed securities from banks. The Fed paid for these financial securities by putting money in the the reserve account that banks had with the Fed. In theory, banks could lend out these reserves. But the flood of quantitative easing money came so fast, and arrived in economic times that were so uncertain, that banks didn't in fact lend out most of the money. In addition, the Fed announced in October 2008 that it would start paying interest on banks reserves--which made the banks feel financially healthier.
As a result of this pattern of events, banks no longer tried to hold the minimum legally required level of reserves at the Fed. Instead, banks as a group were holding reserves several trillion dollars in excess of the legal requirement. As a result, banks no longer had any reason to borrow money in the federal funds market, and given that the Fed was now paying them interest on reserves, they didn't have any reason to lend money in that market, either.
Bottom line: When the Fed talked about conducting monetary policy to raise or lower the federal funds interest rate back in 2007 and earlier, it was talking about an interest rate in a market where banks were borrowers and lenders. But for the last decade or so, banks have little interest in borrowing and lending in the federal funds market. So when the Fed talks about raising or lowering the federal funds interest rate, what entities are actually doing the borrowing and lending in that market?
The main lenders in the federal funds market, as McGowan and Nosal explain, are the Federal Home Loan Banks. These banks have accounts at the Federal Reserve, but do not receive interest payments from the Fed on funds held in these accounts.
The Federal Home Loan Bank system was created by Congress in 1932 to facilitate financing in the U.S. housing market. The FHLBs accomplish this mission by lending to banks that lend in the U.S. housing market. Loans from the FHLBs are called advances. To receive an advance, banks must become members of the lending FHLB, and the advances are typically secured by U.S.-based real estate collateral. The FHLBs fund the advances by issuing securities. FHLBs maintain liquid assets, or buffers, to ensure timely repayment of their security liabilities when due. FHLB liquidity buffer assets typically consist of fed funds sold, Treasury bill securities, and Treasury reverse repo investments. FHLB liquidity buffers also serve as a reserve of liquidity that can be drawn upon to grant member advances on a timely basis.
Because FHLBs are not deposit-taking institutions, they are not subject to reserve requirements and thus are ineligible to earn IOER [interest on excess reserves] from the Fed. Since they are not eligible for IOER, FHLBs are challenged in their efforts to obtain interest income on their liquidity pools. FHLBs have a strong motivation to sell fed funds, since whatever rate they obtain on fed funds transactions is greater than the zero compensation they would receive on any end-of-day balances held in their accounts at the Fed.
The main borrowers in the federal funds market are foreign banking organizations. The incentive to borrow works like this. Say that you are running a bank, and you have some way to borrow money at less than the interest rate that the Fed is paying for reserves. You could then borrow that money at the lower interest rate, deposit it at the Fed and get a higher interest rate, and earn money off the difference. This sort of deal doesn't work well for domestic US banks, because when those banks borrow money and have additional funds, domestic US banks also need to pay extra into the Federal Deposit Insurance Corporation, which provides insurance to bank depositors against the risk that a bank will go broke. However, foreign banking organizations don't have depositors, and don't need to pay insurance premiums to the FDIC. Thus, they are willing to borrow from the Federal Home Loan Banks at an interest rate below what the Fed is paying on reserves, deposit these funds in their reserve account at the Fed, and earn a profit from the gap between the two. As McGowan and Nosal explain:
[M]ost fed funds borrowing transactions are motivated by “IOER arbitrage”—borrowing overnight at a rate below the IOER rate, leaving the funds at the Federal Reserve overnight to earn the IOER rate, and earning a positive spread on the transaction. Foreign banking organizations (FBOs) currently have a large presence in the fed funds market because of their borrowing advantage over domestic banking institutions. Since FBOs do not offer retail deposits, they are exempt from paying Federal Deposit Insurance Corporation (FDIC) insurance assessments, which all domestic banks must pay. The FDIC methodology for calculating these assessments changed in the post-crisis period. They are now based on the size of a bank’s balance sheet and not on the bank’s deposit liabilities, as they were pre-crisis. Borrowing costs are reduced if assessments are lower; in the case of FBOs they are zero.
In the old days before 2007, the Federal Reserve conducted monetary policy by influencing the market for banks that were lending or borrowing their own reserves. Now, the primary tool for conducting monetary policy is the interest rate that the Federal Reserve pays for excess reserves. That interest rate will shape the desire of Federal Home Loan Banks to lend funds and the desire of foreign banking organizations to borrow them--and thus affect the federal funds interest rate.
This description should help to clarify why the federal funds interest rate should not exceed the interest rate on excess reserves paid by the Fed: The foreign banking organizations that are now the main borrowers in the federal funds market are receiving that interest rate on excess reserves, and they will only be willing to borrow at slightly lower interest rate. Although the two rates move together, and sometimes crisscross each other, a common pattern that has emerged is that the federal funds interest rate often hovers a little below (about 10 basis points below) the interest rate paid on excess reserves by the Fed.
What if the federal funds interest rate were to fall substantially below the interest rate on excess reserves? As McGowan and Nosal explain, the Fed has a backup plan, called the "overnight reverse repurchase facility." Basically, this allows the Fed--when necessary--to do short-term borrowing from the Federal Home Loan Banks, so that as a result, those banks won't lend out at less than the interest rate being offered by the Fed through its "overnight reverse repurchase facility." The hope of the Fed is that changing the interest rate paid on excess reserves can be its main tool of monetary policy moving forward, but the overnight reverse repurchase facility is on standby in case a substantial gap opens up between the interest rate on excess reserves and the federal funds interest rate.
Phrased this way, the mechanics of Federal Reserve monetary policy that focuses on the federal funds interest rate sound rather indirect and complex! Take a moment to pity the teacher of introductory economics. Explaining how the old-style monetary policy tools affected the federal funds interest rate had its challenges, but at least you didn't need to start dragging your intro class into the details of Federal Home Loan Banks, foreign banking organizations, the overnight reverse repurchase facility, and so on.
A version of this article first appeared on Conversable Economist.
Timothy Taylor is an American economist. He is managing editor of the Journal of Economic Perspectives, a quarterly academic journal produced at Macalester College and published by the American Economic Association. Taylor received his Bachelor of Arts degree from Haverford College and a master's degree in economics from Stanford University. At Stanford, he was winner of the award for excellent teaching in a large class (more than 30 students) given by the Associated Students of Stanford University. At Minnesota, he was named a Distinguished Lecturer by the Department of Economics and voted Teacher of the Year by the master's degree students at the Hubert H. Humphrey Institute of Public Affairs. Taylor has been a guest speaker for groups of teachers of high school economics, visiting diplomats from eastern Europe, talk-radio shows, and community groups. From 1989 to 1997, Professor Taylor wrote an economics opinion column for the San Jose Mercury-News. He has published multiple lectures on economics through The Teaching Company. With Rudolph Penner and Isabel Sawhill, he is co-author of Updating America's Social Contract (2000), whose first chapter provided an early radical centrist perspective, "An Agenda for the Radical Middle". Taylor is also the author of The Instant Economist: Everything You Need to Know About How the Economy Works, published by the Penguin Group in 2012. The fourth edition of Taylor's Principles of Economics textbook was published by Textbook Media in 2017.