The Fed and Interest Rates: A Floor with a Subfloor

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Today’s post is the second in a two-part series on how the Federal Reserve influences interest rates.

Yesterday’s post explained that the Federal Reserve has moved from a channel system to a floor system regarding the conduct of monetary policy. Today’s post will explain how reality has differed from theory for conducting policy and what the Fed’s solution has been.

Vice President and Economist Stephen Williamson explained that given the large stock of reserves outstanding, the Fed should, in principle, be able to target the federal funds rate (or the interest rate banks charge when they lend to each other overnight) by setting the interest rate on excess reserves (IOER).

However, Williamson noted that the IOER was set at 0.25 percent from late 2008 through December 2015, while the fed funds rate has generally been 5 to 20 basis points lower than the IOER since early 2009. He wrote: “This difference between the IOER and the fed funds rate is typically ascribed to costs for commercial banks associated with borrowing on the fed funds market.”

Williamson noted that the difference between the IOER and the fed funds rate was a concern as the Fed discussed “liftoff,” or a departure from the zero interest rate policy it had followed since late 2008. He wrote: “Could the Fed expect that the fed funds rate would increase along with the IOER if the Fed attempted to control the fed funds rate only through increases in the IOER?”

Williamson noted that “the solution adopted by the Fed is unique in central banking—a floor system with a subfloor.” The subfloor is dictated by the rate on what are called overnight reverse repurchase agreements, or ON-RRPs.

With ON-RRPs, financial institutions lend to the Fed, just like with reserves held at the Fed. The difference is that the Fed puts up securities as collateral.

Williamson noted that the idea behind the floor-with-subfloor system is that the Fed sets an ON-RRP rate in addition to the discount rate and IOER. He wrote: “The ON-RRP rate is set below the IOER, and then policy is announced as a target range for the fed funds rate, with the top of the range given by the IOER and the bottom of the range determined by the ON-RRP rate. Thus, the IOER sets the floor, and the ON-RRP rate sets the subfloor.”

At its Dec. 16 meeting, the Federal Open Market Committee:

• Increased the fed funds rate target range from 0-0.25 percent to 0.25-0.50 percent
• Set the discount rate at 1.0 percent
• Set the IOER at 0.50 percent
• Set the ON-RRP rate at 0.25 percent

Williamson noted that, in the few weeks that followed, the average daily fed funds rate was typically within a range of 0.35-0.37 percent, with one exception. He wrote: “Thus, in terms of results, the Fed has been successful in controlling the fed funds rate within the 0.25-0.50 percent range.”

The one exception was on Dec. 31, when the average fed funds rate was 0.20 percent. At the same time, the value of ON-RRPs outstanding rose to $475 billion from just $105 billion two weeks prior. Williamson noted that the key is the date, “which is important because at this time financial reporting takes place and financial institutions want to have their balance sheets appear as favorable as possible to their shareholders and regulators.”

As Williamson put it, lending to the Fed via ON-RRPs is essentially riskless, while lending on the fed funds market entails some risk. “Therefore, we might expect that, on Dec. 31, lenders in the overnight market would shift their activity from the fed funds market to the ON-RRP market, as this would reduce risk on their balance sheets. Sure enough, we saw a large increase in ON-RRP activity on Dec. 31.”

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