The Federal Reserve is the central bank of the United States and is responsible for the nation’s monetary policy while adhering to its statutory mandate of, “maximum employment, stable prices, and moderate long-term interest rates.”
Stable prices are defined as a long-run goal of 2% inflation.
Responsibility of the Federal Reserve is fourfold:
- Monetary policy;
- Provision of emergency liquidity as the lender of last resort;
- Supervision of certain types of banks and other financial firms; and
- Provision of payment system services to financial firms and the government.
The Federal Open Market Committee (FOMC) consists of 12 Federal Reserve officials and compromises the top monetary policy-making body within the Federal Reserve System by setting the monetary policy objective during the first FOMC meeting each year. The FOMC meet every six to eight weeks.
FOMC meeting minutes are published following the meeting, which decides the monetary policy objectives and contains the Authorization. The Authorization is contained in the meeting minutes following the first FOMC meeting of the year and lends responsibility to FOMC delegates for implementing US monetary policy to the Manager of the System Open Market Account (SOMA) at the Federal Reserve Bank of New York (FedNY). SOMA performs two primary functions: (i) contains assets used for open-market operations (OMOs), and (ii) settles foreign exchange intervention. Note: the Federal Reserve’s holding of securities is contained within SOMA.
Three basic tools are used to carry out monetary policy:
- Temporary and permanent OMOs through the buying and selling of US government securities ;
- Discount Window (DW) and adjustments to its terms and conditions; and
- Reserve requirement ratios of banks regulated by the Federal Reserve.
FedNY performs OMOs on a permanent and temporary outlook:
- Permanent OMOs accommodate the expansion of the Fed’s balance sheet, observed as the velocity of money.
- Temporary OMOs address reserve needs during periods of economic fluctuation.
- Temporary OMOs facilitate the system prior to a long, holiday weekend when banks often hold extra reserves.
- This means the FedNY purchases the government security for a short-period of time, increasing the reserve balances for the period of the agreement until the security is sold back to the original holder. This is an example of a repurchase agreement.
Permanent OMOs involve the purchase and/or sale of securities for the SOMA, while temporary OMOs involve the overnight and term repurchase agreement operations (collectively referred to as “Overnight RRP”). All FOMC OMO directives are performed by the FedNY Open Market Trading Desk (the “Fed Desk”). OMO performed affect the Fed’s balance sheet and FedNY SOMA.
When the Fed Desk increases the supply of reserves to the market, the Funds Rate consequently falls, and vice versa. Thus, it is the responsibility of the SOMA Manager, who manages the Fed Desk and is issued a Directive by the FOMC outlining the rate, to ensure the Funds Rate is to be traded within the Directive until the next FOMC meeting.
The Federal Reserve has, since its inception in 1913, used the DW as the primary instrument of central banking operations. However, the FOMC has become increasingly reliant on OMOs in recent years, especially after the 2007-8 financial crisis. As a result, the role of the DW has been diminished to complement directives from the FOMC in adding/subtracting reserves from the banking system, and thus liquidity of the banking system. In fact, the DW took an additional role between December 2007 and March 2010 in acting as the Term Auction Facility.
This shift has made OMOs the primary tool to influence the aggregate level of settlement balances in the banking system and thereby the Federal Funds Rate (“Funds Rate”). It is important to note that the FOMC does not simply set an interest rate, it sets the Federal Funds Rate which influences the prevailing interest rate – the prevailing interest rate can trail the Funds Rate significantly (as depicted below).
Prior to the 2007/8 financial crisis, OMOs relied on two key features: (i) reserve requirements and (ii) reserve scarcity. Since the Fed sets reserve requirements, banks are required to hold the minimum stipulated reserves on their balance sheet in order to comply and continue to be FDIC-insured. Reserve requirements are an opportunity cost to banks as the capital used obtains a near zero return on capital – something which should be viewed as an operating cost.
Banks must therefore balance the opportunity cost between holding adequate reserve requirements over being penalized for a reserve deficiency. This is the reason banks generally keep reserve balances to a minimum in order to minimize the opportunity cost. As a result, the combination of reserve requirements and banks’ desire to minimize reserves creates an active interbank market for overnight funds. This interbank market is where banks actively borrow from and lend with each other on a daily basis at the Funds Rate. (Jane E. Ihrig, 2015)
The Federal Reserve, prior to the 2007/8 financial crisis, could directly influence the amount of interbank market activity by changing the Funds Rate due to relative scarcity of reserves in the system, which was around $15 billion. As a result of quantitative easing, the amount of reserves stands at $2.6 trillion, as of December 2014.
Where does the Funds Rate influence the prevailing interest rate? When the supply of reserves intersects the downward sloping portion of the demand curve, as shown in Figure 2 of Figure [X] below. For example, if the interest rate in the market (“the Effective Funds Rate”) is below the FOMC target policy rate, the Fed Desk would execute sales of securities, which would drain the reserves balance in the system and shift the supply curve inwards. To have this effect, the demand for reserves needs to be downward sloping, which holds for the following two reasons:
- The market interest rate is the opportunity cost of holding reserves overnight, such that when the rate falls, the opportunity cost of holding excess reserves decreases; and
- There is an inverse relationship between opportunity cost of holding excess reserves and paying the penalty rate (Discount Window) when there is a deficiency of reserves at end-of-day settlement.
Since total reserves held in the system has risen to $2.6 trillion, from $15 billion, in just over 6 years, the Funds Rate or target policy rate is ineffective as the supply of reserve balance curve has been pushed (rightwards) and intersects the non-elastic section of the demand for reserves. The only way in which the Fed Desk could exact an upward influence on the effective Funds Rate, using the pre-financial crisis framework, would be to reduce the total reserves in the system, or in other words increase reserve scarcity. (Jane E. Ihrig, 2015)
Overnight RRP conducted by the Fed Desk consists of repurchase agreements (“RP”) and reverse repurchase agreements (“RRP”) (collectively referred to as “Overnight RRP”). A RP requires the Fed Desk to purchase a US government security from an eligible counterparty who then agrees to consequently repurchase the same US government security at a specified price at a specified time in the future. A RRP is the opposite of a RP, whereby the Fed Desk sells a US government security from an eligible counterparty who then agrees to repurchase the same security at a specified price and time in the future.
The interval of an overnight RP/RRP is one business day . This means the purchase and repurchase is settled within the one day period. The interval of a term RP/RRP transaction can be between 1 and 65 business days.
There are four types of eligible counterparties: primary dealers, banks (domestic and foreign banking offices in the US), government-sponsored enterprises, and money market mutual funds. Eligible counterparties are available on the FedNY website.
The FOMC instructed the Fed Desk in September 2013 to conduct fixed-rate Overnight RRP. This was aimed at controlling the Funds Rate in concert with the Fed’s monetary policy normalization process. Overnight RRP were initially offered to 140 eligible counterparties, eligible up to US$0.5 billion respectively. This limit was raised to US$300 billion by September 2014 even though the number of eligible counterparties only rose from 140 to 164 (counterparty figure as of March 2015).
In recent years, the FOMC has given a further directive to change the size and/or composition of SOMA’s Treasury portfolio – to influence longer-term interest rates:
- Exerting an influence on longer-term interest rates affects the benchmark yield curve, a curve which plots the yield-to-maturity prices of government securities with maturities from 90 days to 30 years.
- For example, a positive-sloped yield curve indicates that investors believe the Fed will raise interest rates in the future, thus reflecting a healthy outlook. The reverse could also be said.
The tripartite layer of responsibility of Federal Reserve policy-making and OMOs look to minimize the discrepancy between the Funds Rate and Effective Rate; however, the structure of the Federal Reserve’s three basic tools was modified when it began paying interest on excess reserves (IOER) to eligible participants in October 2008 in the view of stabilizing the US economy following the subprime mortgage crisis.
The Fed terms excess reserves as a quantity of reserves greater than the notional amount required by law, based on the volume of liabilities on the Fed balance sheet.
The IOER was set at 0.25% and eligible participants could deposit excess overnight funds at the Fed in order to earn a risk-free return of 0.25% on excess reserves. This meant that the Federal Reserve shifted from an asymmetric corridor monetary policy framework (“Asymmetric Corridor”) to a new permanent floor framework (“Permanent Floor”). If the Fed had not shifted its framework, adjustments to short-term interest rates would have been required when conducting quantitative easing and credit easing.
The Asymmetric Corridor meant the Fed could match the supply and demand for non-borrowed reserve balances at the target Funds Rate; such that, if the Federal Reserve undersupplied the demand for non-borrowed reserves, the effective Funds Rate would drop until it reached the rate of the DW.
This is illustrated in Figure A. As eligible BHCs had the option to borrow reserves through the DW, the aggregate supply of reserves becomes perfectly elastic at the DW rate, which effectively acts as a price ceiling. It would be nonsensical for a BHC to borrow overnight funds above the DW rate as a BHC is modeled as profit maximizing.
The shift from an Asymmetric Corridor to Permanent Floor brings the Funds Rate and IOER together and establishes an interest rate floor.
In the case of OMOs between [2009 and 2011], the Federal Reserve shifted its framework to oversupply the system with excess reserves. Oversupply was to the point where eligible BHCs were competing with each other in loaning out reserve balances, until either the oversupply ceased to exist or the effective Funds Rate reached the IOER. This is shown in the above diagrams as the supply of reserve balances went from $15 billion, under Asymmetric Corridor, to $2.8 trillion, under Permanent Floor.
The shift to a Permanent Floor framework can be primarily attributed to previous Fed Chairman Ben Bernanke who based literature and research on the Great Depression to form the new framework. In terms of implementation, the Fed needed US Congress approval to pay IOER, something previously prohibited.
The US Congress passed the Financial Services Regulatory Relief Act of 2006, which amended Section 19 (b) of the Federal Reserve Act, which permitted the Federal Reserve to begin paying IOER at a rate or rates that do not exceed the general level of short-term interest rates. Furthermore, the Emergency Economic Stabilization Act of 2008 allowed the Federal Reserve to begin paying IOER on October 1, 2008, three years ahead of the original scheduled implementation.
The Asymmetric Corridor had an (implied) effective interest rate floor of 0%, since an eligible profit-seeking BHC would have no reason to lend excess reserves at a rate below the prevailing IOER. Therefore, the shift to a Permanent Floor keeps the previous framework of having the DW and IOER act as the ceiling and floor rate respectively – generating an interest-rate corridor system.
The only major difference with the Permanent Floor is that the level of excess reserves pushes the effective Funds Rate up and down, and thereby eliminates the need for OMOs to target a positive effective Funds Rate. The level of excess reserves can push the effective Funds Rate up to the ceiling (DW rate) or down to the floor (IOER rate).
This means the OMOs can now be used to target the level of excess reserves while simultaneously targeting the Funds Rate by adjustments on IOER. This is illustrated as the shift from Figure 2 to Figure 3 of Figure B:
The Federal Reserve is able to control the vertical supply of excess reserves and the horizontal demand for excess reserves independently. However, how has the Permanent Floor performed in achieving the target Funds Rate?
The October 2008 introduction of IOER, at 0.25%, ensured that as the Fed, via quantitative easing measures, increased the size of its balance sheet, through the increase in excess, non-borrowed, reserves, this would simultaneously increase the amount of high-quality liquid assets and push the effective Funds Rate down.
Consequently, the FOMC announcement in December 2015 to raise the target Funds Rate from 0.25% to 0.50%, such that IOER also rose from 0.25% to 0.50%, has been the first uptick from an 8-year period of stagnant rates.  However, the observed spread between the target and effective Funds Rate calls into question what the explanatory factors are for such a material spread.
As Figure C above shows, the spread between target and effective Funds Rate has been material and significant. One explanation for the spread is the liquidity pool.
An arbitrage opportunity for Fed monetary policy counterparties exists as Government-Sponsored Enterprises (GSEs) and foreign BHCs are not allowed to receive interest on their reserve balances. That said, while foreign institutions are not permitted to receive interest on excess reserves,
“a separate, overnight reverse repo facility has long existed as an investment vehicle for foreign central banks and international accounts that hold US dollars in their accounts at the Federal Reserve Bank of New York” (Potter 2013, Page 7).
This means eligible-counterparties take the opportunity to bid up the price of excess reserves, since they are [price-takers] and capture the arbitrage spread; however, an FDIC assessed fee on eligible-BHC participants relating to their balance sheet size thereby reduces the potential return from IOER.
That said, eligible counterparties are only able to capture a partial amount of the arbitrage spread, such that foreign institutions, which are not assessed for FDIC fees, capture the rest of the arbitrage by borrowing from and investing in excess reserves issued from the separate overnight reverse repo facility.
So this leaves the question: if the Permanent Floor does not facilitate the conditions for a convergence in the spread between the effective and target Funds Rate, what is the merit in keeping the Permanent Floor and the Federal Reserve’s Normalization Policy?
The Normalization Policy of the FOMC announced to normalize the monetary policy and security holdings of the Federal Reserve. For monetary policy, the Federal Reserve will continue to rely on the Overnight RRP and IOER to assist the Fed Desk in keeping the target Funds Rate within the FOMC target range; however, the use of Overnight RRP will be phased out once the Funds Rate is operating within the FOMC target range for a consistent period.
For security holdings, the size of SOMA will gradually normalize as the Federal Reserve’s balance sheet shrinks in a gradual and predictable manner, primarily by ceasing reinvestment of repayments of principal on securities held in SOMA. However, as the target Funds Rate increases from 0.25% to 0.50%, what is the impact of the resulting drain on liquidity in the financial system? Furthermore, how will the Federal Reserve achieve its Normalization Policy in light of bureaucratic incentives to push for excess reserves in the system, while an Asymmetric Framework does not require such levels of excess reserves.
 Further information on OMO transaction data: https://www.newyorkfed.org/markets/OMO_transaction_data.html
 For further information: http://www.federalreserve.gov/newsevents/press/monetary/20151216a1.htm
 For further information, please refer to Boettke, Peter J., and Daniel J. Smith. 2013. “Federal Reserve Independence: A Centennial Review”, The Journal of Prices & Markets, 1 (1), 31-48.