Understanding Liquidity and the Fed Funds Rate

This 12-minute podcast was recorded Aug. 2, 2022, and released Oct. 5, 2022, as a part of the Timely Topics podcast series.

Julian Kozlowski, senior economist at the St. Louis Fed

When the federal funds rate increases, it turns out that interest rates for checking, savings or time deposits do not increase by as much, notes Julian Kozlowski, a senior economist at the Federal Reserve Bank of St. Louis. Therefore, people may withdraw money from the banking sector and invest in less-liquid, but higher-return assets. This, in turn, can contribute to a decrease—or “dry-up”— in liquidity in financial markets.

In this Timely Topics podcast episode, Senior Economist Julian Kozlowski talks with Christine Smith from the St. Louis Fed’s external communications team about the opportunity cost of holding cash, the deposit channel of monetary policy and the liquidity premium. He also relays observations about aggregate liquidity in the economy.

Transcript

Christine Smith: Welcome to Timely Topics, a podcast series from the Federal Reserve Bank of St. Louis. Here, we interview economists and experts about their research. My name is Christine Smith and I’ll be your host today, and with us is Julian Kozlowski, who is a senior economist at the St. Louis Fed. Welcome, Julian.

Julian Kozlowski: Hi. Thank you very much for having me.

Smith: There has been a lot of work on the causal links between monetary policy actions and economic effects. So, Julian, you’ve pointed out some active research that we will include in our podcast notes, along with some of your more recent St. Louis Fed articles.

I’m wondering, can you tell our listeners a little bit about the deposits channel of monetary policy? What's a good way to maybe explain it and tell me why you’re studying it?

Kozlowski: Yes. Thank you very much for having me here in the podcast series. You are correct. Over the last few years, we’ve seen a lot of research trying to understand this causal link between monetary policy actions, meaning, for example, increasing interest rates, how is it that this is going to be affecting the aggregate economy.

Think, for example, about the inflation. For example, in a recent paper in the QJE (Quarterly Journal of Economics) issued by Drechsler, Savov and Schnabl, they proposed what is called the deposit channel of monetary policy, and it has been a growing literature that is building on this idea. And this idea basically proposed that, when the Federal Reserve increased the interest rates, the interest rates that consumers have in their bank accounts—think about your checking, your savings, or your time deposits—those interest rates are not increasing as much as the reference rate proposed by the Federal Reserve. And as a consequence, you have that there is less money in the banking sector. The money is flowing into other securities that are, perhaps, less liquid.

Smith: That is very helpful.

Julian, I’m wondering what you just said. Could you give our listeners a framework to think about how households form their portfolios and the types of assets that they may choose to hold?

Kozlowski: Oh, yeah. That’s a good idea, Christine. So, for example, think about the household that has some money and they’re deciding where to allocate that money. So, broadly speaking, there are three categories.

First, you can have cash, you know, money bills, that you can have in your house—in your pocket. Those are fantastic in the sense that they are very liquid. It is the most liquid type of way that you can have your money, and it’s readily available at your house. But it is not going to be paying any interest. So, in the context of high inflation, like what we are living today, it is very costly to have all your money in cash.

The second asset class can be bank deposits. Think about the money that you can have in your checking accounts, your savings accounts or some time deposits. These are perhaps a bit less liquid than cash but, nevertheless, from your phone you can tap them almost everywhere, anytime. And on top of that, you can get some interest, particularly on some savings accounts and in time deposits.

And finally, you can go to the financial markets. You can buy different types of securities in the market, which—these securities are perhaps less liquid than bank accounts and cash, but they’re going to be paying higher interest rates than your money in your bank account.

So, at the end of the day, households are going to be trading off the liquidity service provided by these financial instruments, vis-à-vis with the expected return, to think about how to allocate their money between some cash, some bank deposits, and some other financial instruments.

Smith: That makes total sense. Thank you.

I wonder if we can talk about this in relation to the federal funds rate. In this framework that you described, what happens when the fed funds rate rises?

Kozlowski: That’s an excellent question, Christine. So, now, monetary policy and the interest rate set by the Federal Reserve enters into play. What’s happening when you look at the data is that every time the Federal Reserve increases the reference rate, the interest rates on your bank deposit and your checking, savings or time deposits, they do not increase as much. And as a consequence, what we see in the data is that households and firms withdraw money from their bank accounts and they move toward less-liquid securities. This implies there is going to be a contraction in bank lending as well as a scarcity of liquidity in the economy after an increase in the Federal Reserve interest rate.

Smith: OK. A scarcity of liquidity. So, you mentioned that. Let’s turn to the data. What do the data show when we look back at the past 30 years or so? What has happened historically speaking?

Kozlowski: That’s something where we can look starting in 1987. We can see that there were six periods in which the Federal Reserve increases interest rates. This corresponds to the tightening cycles of 1987, ’93, ’99, 2004, and 2015, as well as this year, 2022. But let me first start with the historical ones, with not going to the current ones. So we have five tightening cycles since 1987. We can broadly speaking identify three facts out of them.

The first fact is that the interest rate paid by the Federal Reserve increases on average by 300 basis points. However, the second fact is that, if you look at bank deposits, for every 100 basis points—that is, 1%—increasing the Federal Reserve interest rate, we only see 36 basis points increase in the deposits’ interest rates. So, that is about one-third. So, for each 1%, the federal funds rate, you only see one-third of a percent increasing in your bank deposit. And the third fact is that, in each of these tightening cycles, we observe an outflow of deposit outside of the banking center.

Smith: OK. So it became very expensive to keep money in the bank, then?

Kozlowski: Yes.

Smith: So, I'd like to take a quick break here to invite our listeners to check out the St. Louis Fed's Central Banker e-newsletter. Twice a month, Central Banker will arrive in your inbox, and it'll bring you the latest interviews, articles, podcast episodes and more. It's all the economic content that you could want from a trusted resource, the St. Louis Fed. Sign up today at stlouisfed.org.

Smith: All right. Let’s get back to our interview. Now, what is happening more recently with deposit rates?

Kozlowski: That’s a good point. As you probably know, since the beginning of the year, the Federal Reserve has been increasing the fed funds rate. In fact, it increased from around zero percent at the beginning of the year to 250 basis points today. That is 2.5%. However, when we look at what’s happening with bank deposits in the data on checking, savings or time deposits, they did not increase at all during this year. As a consequence, if you think about you and me as consumers in this economy, the opportunity cost of having our money in bank accounts, in our savings accounts and the time deposits, increased a lot during 2022. Perhaps nowadays, the consumers may want to consider or reallocate their portfolios to where the securities are perhaps are less liquid, but they pay higher interest rates in financial markets.

Smith: Ah, OK. So, as you noted, the opportunity cost of holding cash in deposits can become more costly when higher rates are available elsewhere, like in more illiquid instruments.

Is there any signal in financial markets that you are observing, Julian, that points to the fact that liquidity is starting to dry up?

Kozlowski: That's an excellent point and, for me, that is a key variable to look nowadays on financial markets. However, measuring liquidity is really, really hard. Let me propose something that we can do. The ideal exercise is to compare two assets that are identical, except that one provides more liquidity than the other. For example, we can compare on the one hand the three-month Treasury bill compared with, for example, a three-month AA commercial paper. Both of these securities have a maturity of three months, so the same maturity, and both of them are considered very, very safe. So, default probability on either Treasury bills or these commercial papers is basically zero. You are not exposed to the full risk. However, T-bills are much more liquid than commercial papers. And so, perhaps, in financial markets, they might trade at different rates and we can use that variation to quantify how is this stance of the liquidity in the market. If you look at this measure, this is what is called the liquidity premium or liquidity spread.

If you look at these data, during last year, 2021, when the federal interest rate was at zero, both of these securities were bearing the same rate. So, there was no liquidity premium. In other words, last year we had a lot of liquidity in the markets, and so consumers were not asking for a higher premium to hold these illiquid assets because there was a lot of abundant liquidity in the economy.

However, this year, in particular in the last few months, we started to see a positive liquidity premium, which means that there is more demand for liquidity in the markets, and now the fact that these commercial papers are liquid relative to T-bills are starting to pay a premium on the interest rate they pay. And so, for me, this is a key variable to look at in this year. This, again, are signs that there is some dry-up of liquidity in financial markets.

Smith: As a final thought, what could be some implications of less liquidity?

Kozlowski: This is a very interesting question. Personally, I believe that this dry-up of liquidity in the market can help us perhaps in the month ahead to reduce the high numbers of inflation that we have seen over the last few months. I think that, looking at the amount of liquidity in the markets, it’s going to be very important to see how inflation responds to it, but this is, to waiting to see exactly the details of how this works is quite complicated.

So, perhaps we can leave this question open for a future podcast. What do you think?

Smith: I think that sounds like a great idea. I think our listeners would love to hear more about this and your research. Thank you so much for your time today. Listeners, you can check out Julian's research into liquidity at stlouisfed.org, and as I mentioned at the top of the show, we will include links to that in our show notes. So, thank you so much for being here.

Kozlowski: Thank you very much for having me in the program. I'm very happy to be here with you today.

Smith: And you can listen to all of our Timely Topics podcasts on stlouisfed.org or on your favorite podcasting app.

Podcast Notes and References

1. Active research on the links between monetary policy and macroeconomic effects includes: The Deposits Channel of Monetary Policy by Drechsler, Savov and Schnabl (QJE 2017); the redistribution channel by Auclert (AER 2019); the investment channel by Ottonello and Winberry (ECMA, 2020); the turnover-liquidity transmission mechanism by Lagos and Zhang (AER 2020); and Tobin’s q channel by Lagos and Jeenas (WP 2022).
2. See Kozlowski’s recent Federal Reserve Bank of St. Louis articles: Liquidity Dries Up, Economic Synopses, Aug. 23, 2022, and Market Liquidity and the Quantity Theory of Money, On the Economy, Aug. 29, 2022.